Morten O. Ravn | Macro Paper Warehouse

Deep Habits

Habit-formation models, internal or external, standardly assume households form habits over a single aggregate good, which means habits change macroeconomic propagation only through aggregate demand and possibly labour supply. This paper asks what changes if habits are instead formed variety by variety – over clothing, vacation destinations, music, cars – a specification the authors call “deep habits” and argue is the more compelling reading of the evidence, citing Houthakker and Taylor’s classic demand work and the marketing literature finding that brand choices depend on past brand choices. Two consequences follow. The demand side is unaffected: the consumption Euler equation is indistinguishable from the superficial-habit case, so existing Euler-equation estimates of habit strength carry over. The supply side changes fundamentally, because firms now recognise that today’s sales raise tomorrow’s demand through habit, making the pricing problem dynamic. Demand for an individual variety splits into a price-elastic term and a perfectly inelastic term coming from habitual consumption of that good, so the short-run price elasticity is a weighted average of the elasticity of substitution and zero – smaller than the elasticity of substitution, and rising when aggregate demand rises because the inelastic component shrinks in relative weight. Since the mark-up is inversely related to the elasticity, mark-ups fall in expansions: the “price-elasticity effect.” A second, “intertemporal” channel operates because firms invest in customer base by cutting mark-ups when the present value of future per-unit profits is high, which also makes the mark-up rise with the real interest rate. Together these deliver a central result – mark-ups are countercyclical in response to preference, government-spending and productivity shocks – which matters because ad hoc general equilibrium customer-market and switching-cost models had been criticised by Rotemberg and Woodford precisely for implying procyclical mark-ups; the authors’ answer is that once demand is derived from optimising households rather than assumed, the prediction reverses. Embedding the mechanism in a full real-business-cycle model with capital, labour supply and government, and estimating the habit parameters by nonlinear GMM on U.S. quarterly data for 1967:Q1-2003:Q1 (exploiting supply-side restrictions absent from Euler-equation-only estimation) gives a habit strength of 0.86, a habit-stock persistence of 0.85, an elasticity of substitution across varieties of 5.3 and a curvature parameter of 2, with the remaining calibration targets taken from Rotemberg and Woodford to make the comparison direct; the implied steady-state mark-up is 1.32, which the authors describe as “somewhat high,” against 1.23 in the no-deep-habit case. Quantitatively, a preference shock worth 1% of steady-state habit-adjusted consumption cuts the mark-up by about 0.4% and raises wages by about 0.3%, where under superficial or no habits wages fall. A 1% government-spending shock cuts mark-ups by about half a per cent, raises real wages, and – against the standard neoclassical prediction – raises private consumption, in line with evidence from Fatás-Mihov, Blanchard-Perotti and Galí-López-Salido-Vallés, though the authors are explicit that “the deep-habit model underpredicts the magnitude of the consumption increase.” The model’s conditional correlation between labour productivity and output is 0.33 under government-purchases shocks and 0.72 under preference shocks, against an unconditional figure of 0.34 reported by Cooley and Prescott, where the superficial-habit model gives -0.1 and -0.85. Three extensions separate the mechanisms: good-specific subsistence points isolate the price-elasticity effect and still give countercyclical mark-ups, but the movements are too small to deliver procyclical wages or procyclical consumption after a government-spending shock; relative deep habits isolate the intertemporal effect, whose sign then depends on whether a shock raises the habit-forming or the non-habit-forming component of demand; and internal deep habits make the monopolist’s pricing problem time inconsistent, a case the authors flag as “beyond the scope of this paper” and “perhaps, the most relevant next step in this research programme.”

Financial Frictions: Micro versus Macro Volatility

Research Question. How do consumer credit spreads — the gap between household borrowing rates and deposit rates — affect aggregate business cycle dynamics and the distribution of consumption across the wealth distribution? And what is the welfare trade-off between macroeconomic stabilization and household-level consumption volatility when bank capital requirements are tightened?

Data and Empirical Approach. The empirical analysis draws on Danish administrative register data for 2003–2018, combining approximately 15.5 million household-year observations. Income tax return data, which capture housing wealth, portfolio wealth, bank deposits, and bank and mortgage debt, are merged with bank-level reporting of interest rates submitted to Danmarks Nationalbank (MFI data). Household-specific credit spreads are constructed as the difference between the loan rate at a household’s primary loan bank and the deposit rate at its primary deposit bank in a given year. Consumption is imputed from household balance sheets following the method of Crawley and Kuchler (2023). The empirical specifications include household and time fixed effects, and quantile regressions are run across bins of the net wealth distribution.

Macroeconomic Fluctuations with HANK & SAM: an Analytical Approach

This is a HANK model built to be solved on paper rather than on a computer. The motivation is stated as a gap in the literature: HANK models “have had a considerable impact on macroeconomics,” but “due to the complexity of such models, the literature has focused on numerically solved models and therefore little is known about their general properties.” The construction grafts Diamond-Mortensen-Pissarides search and matching frictions onto a monopolistically competitive economy with Rotemberg price adjustment costs, so that job prospects are uncertain and households can only self-insure. Tractability comes from three assumptions — no shorting equity and borrowing only by the employed, heterogeneity in both labour productivity and equity access, and exactly two household types — which together imply that “firms are owned by capitalists who drop out of bond and labor markets, while workers hold no equity and are either employed or unemployed,” everyone consumes their income period by period, and the real interest rate satisfies the employed workers’ Euler equation. The result is an economy with “inequality in outcomes but the wealth distribution is degenerate,” which is what makes it analytically solvable. The new object is an endogenous earnings risk wedge in the employed workers’ Euler equation, pinned down by labour market tightness because tightness determines both transition rates and wages. Because those two forces oppose each other — a tighter market means less unemployment risk but a larger income loss if the job is lost — the wedge can be countercyclical or procyclical, and every result turns on which. The authors argue countercyclicality is empirically plausible on three grounds: Storesletten, Telmer and Yaron’s finding that idiosyncratic risk is strongly countercyclical, Guvenen, Ozkan and Song’s finding that it comes from increased left-skewness in recessions rather than countercyclical variance, and a direct evaluation of the wedge using a 25.2 percent monthly job finding rate and 2 percent monthly job loss rate from CPS data (January 1990 to August 2019), a 20 percent consumption drop on job loss following Karabarbounis and Chodorow-Reich, and a wage semi-elasticity of −0.16 for job stayers from Gertler, Huckfeldt and Trigari. On that evaluation “the countercyclical effect of unemployment risk clearly dominates,” failing only when a 5 percent consumption drop is combined with a wage elasticity of −1.5. Four results follow. The economy may have three steady states rather than two, including an unemployment trap with a zero job finding rate and inflation between the intended steady state’s and the liquidity trap’s, which “cannot exist if prices are flexible, if markets are complete, or, if prices are sticky, when the endogenous earnings risk is either acyclical or procyclical.” The Taylor principle no longer suffices for local determinacy of the intended steady state, because “expectations of higher inflation may be self-fulfilling even if the central bank were to stabilize the direct impact of inflation on the real interest rate since demand (and thus inflation) is also stimulated by a decline in unemployment risk.” Nominal rigidities and market incompleteness become complements, so stickier prices can amplify productivity shocks and positive productivity shocks can be inflationary — which the authors support with a local projection of CPI inflation on Fernald TFP growth from 1980, where “higher TFP either leaves inflation unchanged or gives rise to higher inflation.” And the long-run real interest rate depends on policy parameters, while a liquidity trap need not be deflationary. The scope condition is theirs: “while our analysis rests on the analytical convenience produced by the simplifying assumptions that we make, we believe that the insights are general and apply to models with a non-degenerate wealth distribution and with more complicated asset structures” — a belief, supported by a numerical extension with capital accumulation, not a demonstration.