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Incomplete Cost Pass-Through Under Deep Habits
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1725-6704
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EUI ECO; 2008/06
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RAVN, Morten O., SCHMITT-GROHE, Stephanie, URIBE, Martin, Incomplete Cost Pass-Through Under Deep Habits, EUI ECO, 2008/06 - https://hdl.handle.net/1814/7863
Abstract
A number of empirical studies document that marginal cost shocks are not fully
passed through to prices at the firm level and that prices are substantially less volatile
than costs. We show that in the relative-deep-habits model of Ravn, Schmitt-Grohé,
and Uribe (2006), firm-specific marginal cost shocks are not fully passed through to
product prices. That is, in response to a firm-specific increase in marginal costs, prices
rise, but by less than marginal costs leading to a decline in the firm-specific markup of
prices over marginal costs. Pass-through is predicted to be even lower when shocks to
marginal costs are anticipated by firms. In our model unanticipated firm-specific cost
shocks lead to incomplete pass-through (or a decline in markups) of about 20 percent
and anticipated cost shocks are associated with incomplete pass-through of about 50
percent. The model predicts that cost pass-through is increasing in the persistence of
marginal cost shocks and U-shaped in the strength of habits. The relative-deep-habits
model implies that conditional on marginal cost disturbances, prices are less volatile
than marginal costs.