NBER WORKING PAPER SERIES

PRICING TO HABITS AND THE LAW OF ONE PRICE Morten Ravn Stephanie Schmitt-Grohe Martin Uribe Working Paper 12731 http://www.nber.org/papers/w12731

NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 December 2006

The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research. © 2006 by Morten Ravn, Stephanie Schmitt-Grohe, and Martin Uribe. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.

Pricing to Habits and the Law of One Price Morten Ravn, Stephanie Schmitt-Grohe, and Martin Uribe NBER Working Paper No. 12731 December 2006 JEL No. E3,F4 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