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PRICING TO HABITS AND THE LAW OF ONE PRICE Morten Ravn Stephanie Schmitt-Grohe Martin Uribe Working Paper 12731 http://www.nber.org/papers/w12731

NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 December 2006

The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research. © 2006 by Morten Ravn, Stephanie Schmitt-Grohe, and Martin Uribe. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.

Pricing to Habits and the Law of One Price Morten Ravn, Stephanie
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Box 90097 Durham, NC 27708 and NBER grohe@duke.edu Martin Uribe Department of Economics Duke University Durham, NC 27708-0097 and NBER uribe@duke.edu

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Introduction

A long-standing puzzle in open economy macroeconomics is the fact that prices of the same good across countries, expressed in the same currency, not only differ but differ widely and persistently over the business cycle. The observed deviations from the law of one price hold even for individual goods that are actively traded internationally and even in the absence of tariffs or quotas (see Pinelopi Goldberg and Michael Knetter, 1997, and Mario Crucini and Mototsugu Shintani, 2006). In this paper, we propose a novel approach to explaining the observed violations in the law of one price. We embed the deep habit mechanism due to Ravn, Schmitt-Groh´, and e Uribe (2006a) into a two-country dynamic general equilibrium model. We show that when habits are formed at the level of individual goods, as opposed to at the level of aggregate consumption goods, firms have an incentive to lower markups in markets where aggregate demand is strong and to raise markups in markets where demand is weak. In equilibrium, firms price discriminate across markets exhibiting different ratios of current to habitual demand. We refer to this type of price discrimination as

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