Deep Habits and Exchange Rate Pass-Through

40 Pages Posted: 20 Apr 2016

See all articles by Punnoose Jacob

Punnoose Jacob

Reserve Bank of New Zealand

Lenno Uusküla

Bank of Estonia

Date Written: April 2016

Abstract

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 flexible. 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.

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

JEL Classification: F41, E31

Suggested Citation

Jacob, Punnoose and Uusküla, Lenno, Deep Habits and Exchange Rate Pass-Through (April 2016). CAMA Working Paper No. 17/2016 , Available at SSRN: https://ssrn.com/abstract=2767290 or http://dx.doi.org/10.2139/ssrn.2767290

Punnoose Jacob (Contact Author)

Reserve Bank of New Zealand ( email )

2 The Terrace
PO Box 2498
Wellington, 6140
New Zealand

Lenno Uusküla

Bank of Estonia ( email )

Estonia Building 13
15095 Tallinn
Estonia

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