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