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. We show that empirical findings on the effects of a fiscal expansion can be easily reconciled with the neoclassical model by relaxing the assumption of time separability in utility. In line with recent empirical evidence, consumption is weakly responsive, investment expenditure is crowded-out by public spending on impact and the short-term current account deficit episode is driven by the drop in savings. For the benchmark parametrization, the size of expenditure multipliers falls in the range of empirical estimates. The sensitivity analysis shows that the effectiveness of fiscal policy decreases as consumption inertia gets stronger. Finally, we find that as long as agents display a habit-forming behavior, the multiplier rises with labor responsiveness but is smaller than unity