Ester faia universitat pompeu fabra imop ecb dynamic macroeconomic conference hydra 11 june 2005
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Ester Faia, Universitat Pompeu Fabra IMOP/ ECB Dynamic Macroeconomic Conference, Hydra, 11 June 2005 . ‘’Deep Habits’’ by Morten Ravn, Stephanie Schmitt Grohe and Martin Uribe. The scope of the paper . Embed habit formation for varieties into a dynamic general equilibrium model

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‘’Deep Habits’’ by Morten Ravn, Stephanie Schmitt Grohe and Martin Uribe

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Ester faia universitat pompeu fabra imop ecb dynamic macroeconomic conference hydra 11 june 2005

Ester Faia, Universitat Pompeu Fabra

IMOP/ ECB Dynamic Macroeconomic Conference,

Hydra, 11 June 2005

‘’Deep Habits’’ by Morten Ravn, Stephanie Schmitt Grohe and Martin Uribe


The scope of the paper

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:

  • Countercyclical mark-ups

  • Pro-cyclical real wages and co-movements between employment and output

  • Consumption demand rises in response to government expenditure shocks


The main channels of shock propagation

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

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

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

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 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

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

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

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

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.


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