4/2016 Punnoose Jacob and Lenno Uusküla. Deep habits and exchange rate pass-through


Working Papers of Eesti Pank 4/2016

Habit persistence at the level of individual goods varieties can explain incomplete exchange rate pass-through to international prices. Deep habits give rise to a dynamic import demand function that leads to import price markup adjustments, independently of nominal pricing frictions. Augmenting a standard New Keynesian two-country model with deep habits, we obtain low exchange rate pass-through to import prices even when local currency prices are relatively exible. As prices become more rigid, the presence of deep habits further reduces the pass-through of exchange rate fluctuations. Without deep habits, the model requires implausibly high degrees of price stickiness to match the pass-through dynamics triggered by an exchange rate shock in a vector autoregression.

JEL classification: F41, E31

DOI: 10.23656/25045520/42016/0006

Keywords: Exchange Rate Pass-through, Deep Habits, Sticky Prices, Price Markups, Local Currency Pricing

E-mail: lenno.uuskyla [at] eestipank.ee

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The views expressed are those of the authors, and do not necessarily represent the official views of the Reserve Bank of New Zealand, the Bank of Estonia or the Eurosystem.