Habit Formation and the Gains from Price Stability∗

A counter-intuitive result from consumer theory is that consumers facing stable prices will benefit from a mean-preserving spread of those prices (Waugh 1944). This paper explores a new explanation for why the common intuition that price volatility is undesirable may be correct: the presence of habit formation in consumption. If prices are fluctuating, and preferences depend on past consumption, in every period the most favored goods can also be the most expensive ones, with negative consequences for both welfare and nutrition. ∗Thanks to Angus Deaton, Michael Rothschild, Penny Goldberg, Gene Grossman, Seema Jayachandran, Rohini Pande, an anonymous referee and participants at the CESifo Workshop on Malnutrition in South Asia. †Department of Economics, Yale University, 27 Hillhouse Ave., CT 06511. E-mail: [email protected]