We’ve posted over the past couple of days about habit persistence and you might be wondering why anyone would care. It turns out that habit persistence is extremely powerful in explaining some important macroeconomic dynamics:
When habits are formed at the level of individual goods, firms take into account the fact that the demand they will face in the future depends on their current sales. This is because higher consumption of a particular good in the current period makes consumers, all other things equal, more willing to buy that good in the future through the force of habit. Thus, when habits are deeply rooted, the optimal pricing problem of the firm becomes dynamic.
[This paper embeds] the deep-habit-formation assumption in an economy with imperfectly competitive product markets. This combination results in a model of endogenous, time-varying markups of prices over marginal cost [with] markups [that] behave counter-cyclically. In particular, expansions in output driven by demand shocks are accompanied by declines in markups. This implication …is in line with the existing empirical literature. In addition, …because of the strong counter-cyclical movements of markups, [habit persistence] is capable of explaining increases in wages and consumption in response to a positive demand shock as is observed in the data. This latter empirical regularity has proved difficult to explain with standard models of the transmission of demand shocks.