Habit persistence and effectiveness of fiscal policy in an open economy

An open economy version of the Baxter and King's [1993] model is constructed with habit formation to investigate the dynamic and steady-state effects of an expansionary budget policy. In line with empirical evidence, consumption is weakly responsive, investment is crowded out, the drop in savings drives the current account into deficit and government spending multipliers display small values. The sensitivity analysis shows that the effectiveness of the fiscal policy (1) decreases as habit persistence gets stronger, (2) increases with labor supply responsiveness, (3) falls with trade integration. Finally, we find that habit persistence weakens the connection between government spending multipliers and both the elasticity of labor supply and exports-to-GDP ratio.