DP7128 Deep Habits and the Dynamic Effects of Monetary Policy Shocks

Author(s): Morten O Ravn, Stephanie Schmitt-Grohé, Martín Uribe, Lenno Uusküla
Publication Date: January 2009
Keyword(s): countercyclical markup, deep habits, inflation persistence, monetayr policy shocks, price puzzle
JEL(s): E21, E31, E32, E52
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=7128

This paper introduces deep habits into a sticky-price sticky-wage economy and asks whether the countercyclical markup movements induced by deep habits is helpful for accounting for the dynamic effects of monetary policy shocks. We find that this is the case: When allowing for deep habits, the model can account very precisely for the persistent impact of monetary policy shocks on aggregate consumption and for the impact on inflation that other models have hard a time explaining. In particular, the model can account both for the price puzzle and for inflation persistence. We also show that the deep habits mechanism and nominal rigidities are complementary: The deep habits model can account for the dynamic effects of monetary policy shock at low to moderate levels of nominal rigidities. We show that the results are stable over time and are not caused by monetary policy changes.