Pricing to Habits and the Law of One Price

Morten Ravn (), Schmitt-Grohé, Stephanie and Martín Uribe

No 6030, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: This paper proposes a novel international transmission mechanism based on the assumption of deep habits. The term deep habits stands for a preference specification according to which consumers form habits on a good-by-good basis. Under deep habits, firms face more elastic demand functions in markets where nonhabitual demand is high relative to habitual demand, creating an incentive to price discriminate. We refer to this type of price discrimination as pricing to habits. In the presence of pricing to habits, innovations to domestic aggregate demand induce a decline in markups in the domestic country but not abroad, leading to a departure from the law of one price. In this way, the proposed pricing-to-habit mechanism can explain the observation that prices of the same good across countries, expressed in the same currency, vary over the business cycle. Furthermore, it can account for the empirical fact that in response to a positive domestic demand shock, such as an increase in government spending, the real exchange rate depreciates, domestic consumption expands, and the trade balance deteriorates.

Keywords: countercyclical markup; deep habits; government spending; Law of one price; real exchange rate (search for similar items in EconPapers)
JEL-codes: E32 F30 F41 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-ifn and nep-mac
Date: Written
View list of references View citations in EconPapers

Downloads: (external link)
http://www.cepr.org/pubs/dps/DP6030.asp (application/pdf)
CEPR Discussion Papers are free to download for our researchers, subscribers and members. If you fall into one of these categories but have trouble downloading our papers, please contact us at subscribers@cepr.org

Related works:
Working Paper: Pricing to Habits and the Law of One Price (2006)
Working Paper: Pricing to Habits and the Law of One Price (2006)
Journal Article: Pricing to Habits and the Law of One Price (2007)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: http://EconPapers.repec.org/RePEc:cpr:ceprdp:6030

Ordering information: This working paper can be ordered from
http://www.cepr.org/pubs/dps/DP6030.asp

Access Statistics for this paper

More papers in CEPR Discussion Papers from C.E.P.R. Discussion Papers
Address: Centre for Economic Policy Research, 53--56 Great Sutton Street, London EC1V 0DG
Series data maintained by ().