1. Deep Habits Morten Ravn (EUI) Stephanie Schmitt-Grohé (Duke) Martín Uribe (Duke)

2. Existing Literature Habits are formed at the level of an aggregate good. (Superficial Habits) –Has demand side effect Euler equation: –But, no supply side effects! Demand function for good i as in a model without habits: where

3. Deep Habits This paper: Habits are formed at the level of individual goods. –Demand side (Euler equation) is identical under deep and superficial external habits. –However, supply side of the economy changes in fundamental ways: two implications where

4. Price-elasticity Effect (I) Demand now has 2 components: one is price elastic and one is price inelastic; Price elasticity of demand for each good is increasing in aggregate demand (xt). – Price elasticity procyclical;

5. Price-elasticity Effect (II) Fact: price mark-ups are inversely related to price elasticity of demand; This implies that the behavior of mark-ups is countercyclical! This is in line with empirical evidence

6. Intertemporal Effect Under deep habits firm´s pricing problem becomes dynamic: each current unit of good i sold will affect its future sales (magnitude of effect depends on the interest rate)

7. Fully-fledged Model Slow decay in habits: capital accumulation introduce government (budget entirely financed by lump-sum taxes) -government consumption is subject to deep habit formation

8. Aggregate Dynamics

9. Main Results As stated in the equilibrium conditions, deep habits cause the price elasticity of demand to be procyclical (hence mark-ups to be countercyclical); This implies: i)Procyclical real wages ii)Consumption increase with expenditure shocks

10. Extensions Isolating each of the deep habits’ effects: –Price elasticity effect: –Intertemporal effect:

11. Conclusions Deep habit formation implies that producers face demand functions that depend on past sales, inducing a theory of endogenous markup determination. Under deep habits markups are countercyclical, which is in line with empirical evidence. This has implications on the impulse responses of wages and private consumption to an exogenous government expenditures shock: both variables increase, which is also in line with the data (Gali et al., 2003; Blanchard and Perotti, 2002; Fatás and Mihov, 2001).