Deep habits and exchange rate pass-through

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.