‘’Deep Habits’’ by Morten Ravn, Stephanie Schmitt Grohe and Martin Uribe Ester Faia, Universitat Pompeu Fabra IMOP/ ECB Dynamic Macroeconomic Conference, Hydra, 11 June 2005

The scope of the paper Embed habit formation for varieties into a dynamic general equilibrium model Analytically this has two effects:  Demand side: each variety depends on past levels as in the model with superficial habits  Supply side: time varying wedge between marginal product and marginal cost of labour (the mark-up) The goal is to replicate two main stylized facts: 1. Countercyclical mark-ups 2. Pro-cyclical real wages and co-movements between employment and output 3. Consumption demand rises in response to government expenditure shocks

The main channels of shock propagation Price-elasticity effect: as demand for single variety rises the price elastic term increases relatively to the habitual term hence total demand elasticity rises => mark-up decreases. - This effect distinguishes deep habits from superficial habits. The inter-temporal effect: if firms expect a future increase in demand they have an incentive to reduce mark-ups today to increase customer base. - This effect distinguishes deep habits from other theories of endogenous mark-up.

How does this channel modifies the real business cycle model? It amplifies output, employment and real wages fluctuations adding endogenous business cycles Demand rises, mark-up falls hence demand rises again If the wedge between marginal product and marginal cost of labour falls labour demand rises. It overturns consumption fluctuations under government expenditure shocks => it introduces a keynesian wealth effect which counteracts the crowding out effect

Is the model compatible with labour market fluctuations? Wages and labour productivity are pro-cyclical but not so much pro-cyclical Real business cycle models, sticky prices and matching frictions models have all been criticized because real wages were too responsive to aggregate shocks. Wages stickiness is the most obvious way to amend this counterfactual feature. In general RSGU should report more statistics concerning labour market variables

Deep habits together with nominal frictions If demand falls and prices are sticky firms accommodate the reduction in demand by cutting real wages (even more under deep habits) Real wage sensitivity is transferred to marginal costs and inflation This contrasts with strong empirical evidence on inflation persistence

The implications for financial markets The endogenous mark-up also introduces a wedge between the marginal product and the marginal cost of capital hence it should also amplify asset return fluctuations Additionally if one introduces a market for firms shares the value of a firm would vary endogenously with the mark-up => This is an alternative way to introduce endogenous asset price fluctuations

Do ``deep habits´´ help explain inflation persistence under nominal frictions? Deep habits in a sticky price model produce the following Phillips curve: Inflation persistence arises from the dependence with past output => BUT this is so even in the case of superficial habits where stickiness in demand reduces the elasticity of marginal costs (hence of inflation) to output. Inflation inertia is also generated with ``rule of thumb producer´´ = > we need identifying whether inflation inertia is obtained through the introduction of past inflation or past output. Hence: the identification of alternative models is probably very weak=> it depends on the shape of the lag structure

The effects of government expenditure shock In response to government expenditure shocks deep habits generate an increase in private consumption => increase in real wages adds a keynesian wealth effect which overturn the crowding out However the same effect is obtained by postulating incomplete markets (see Gali´, Lopez- Salido and Valles) => agents only consume their labour income. How do we identify the ultimate cause of the increase in private consumption?

Implications for optimal monetary and fiscal policy The model introduces a time-varying wedge on labour and capital This might clearly have implications for optimal monetary and fiscal policy Would it be optimal to tax capital to offset the time-varying wedge on investment?

Conclusions An interesting and carefully done analysis with many extensions It is necessary to explore further the implications labour market variables and inflation to see whether deep habits fully satisfy empirical evidence I believe it is worth exploring implications for financial markets and optimal policy.