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Pricing to Habits and the Law of One Price

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  • Morten Ravn
  • Stephanie Schmitt-Grohe
  • Martin Uribe

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.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12731.

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Date of creation: Dec 2006
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Publication status: published as Morten O. Ravn & Stephanie Schmitt-Grohé & Martín Uribe, 2007. "Pricing to Habits and the Law of One Price," American Economic Review, American Economic Association, vol. 97(2), pages 232-238, May.
Handle: RePEc:nbr:nberwo:12731

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  1. Jordi Galí & J. David López Salido & Javier Vallés, 2003. "Understanding the effects of government spending on consumption," Banco de Espa�a Working Papers, Banco de Espa�a 0321, Banco de Espa�a.
  2. Froot, Kenneth A & Klemperer, Paul D, 1989. "Exchange Rate Pass-Through When Market Share Matters," American Economic Review, American Economic Association, American Economic Association, vol. 79(4), pages 637-54, September.
  3. Ravn, Morten O. & Schmitt-Grohé, Stephanie & Uribe, Martín, 2004. "Deep Habits," CEPR Discussion Papers, C.E.P.R. Discussion Papers 4269, C.E.P.R. Discussion Papers.
  4. Crucini, Mario J. & Shintani, Mototsugu, 2008. "Persistence in law of one price deviations: Evidence from micro-data," Journal of Monetary Economics, Elsevier, Elsevier, vol. 55(3), pages 629-644, April.
  5. Pinelopi K. Goldberg & Michael M. Knetter, 1996. "Goods Prices and Exchange Rates: What Have We Learned?," NBER Working Papers 5862, National Bureau of Economic Research, Inc.
  6. Ravn, Morten O. & Schmitt-Grohé, Stephanie & Uribe, Martín, 2007. "Pricing to Habits and the Law of One Price," CEPR Discussion Papers, C.E.P.R. Discussion Papers 6030, C.E.P.R. Discussion Papers.
  7. Jordi Galí & Pau Rabanal, 2004. "Technology Shocks and Aggregate Fluctuations," IMF Working Papers, International Monetary Fund 04/234, International Monetary Fund.
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Cited by:
  1. Lukasz A. Drozd & Jaromir B. Nosal, 2012. "Understanding International Prices: Customers as Capital," American Economic Review, American Economic Association, American Economic Association, vol. 102(1), pages 364-95, February.
  2. International Monetary Fund, 2010. "Fiscal Policy and the Current Account," IMF Working Papers, International Monetary Fund 10/121, International Monetary Fund.
  3. Margarita Katsimi & Vassilis Sarantides, 2009. "The Impact of Fiscal Policy on Profits," CESifo Working Paper Series 2849, CESifo Group Munich.
  4. Lukasz Drozd, 2012. "Pricing To Market In Business Cycle Models," 2012 Meeting Papers, Society for Economic Dynamics 1108, Society for Economic Dynamics.
  5. Giancarlo Corsetti & Luca Dedola & Sylvain Leduc, 2010. "Optimal monetary policy in open economies," Working Paper Series, Federal Reserve Bank of San Francisco 2010-13, Federal Reserve Bank of San Francisco.
  6. Maurice J. Roche & Michael J. Moore, 2007. "Solving Exchange Rate Puzzles with neither Sticky Prices nor Trade Costs," Economics, Finance and Accounting Department Working Paper Series, Department of Economics, Finance and Accounting, National University of Ireland - Maynooth n1750507, Department of Economics, Finance and Accounting, National University of Ireland - Maynooth.
  7. Ariel Burstein & Gita Gopinath, 2013. "International Prices and Exchange Rates," NBER Working Papers 18829, National Bureau of Economic Research, Inc.
  8. Maurice J. Roche & Michael J. Moore, 2010. "For Rich or for Poor: When does Uncovered Interest Parity Hold?," Working Papers, Ryerson University, Department of Economics 015, Ryerson University, Department of Economics.
  9. Drozd, Lukasz A. & Nosal, Jaromir B., 2010. "Pricing to Market in Business Cycle Models," MPRA Paper 22513, University Library of Munich, Germany.
  10. Morten O. Ravn & Stephanie Schmitt-Grohé & Martín Uribe, 2007. "Pricing to Habits and the Law of One Price," American Economic Review, American Economic Association, American Economic Association, vol. 97(2), pages 232-238, May.
  11. Chang, Ming-Jen & Chang, Juin-Jen & Shieh, Jhy-Yuan, 2014. "Keeping up with the Joneses and exchange rate volatility in a Redux model," International Review of Economics & Finance, Elsevier, Elsevier, vol. 29(C), pages 569-584.
  12. Alessio Emanuele BIONDO, 2010. "The Law of One Price: Survey of a Failure," Theoretical and Practical Research in Economic Fields, ASERS Publishing, ASERS Publishing, vol. 0(2), pages 168 - 182, December.

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