Habits, Costly Investment, and Current Account Dynamics

Using a small country model with habit-forming consumers and costly investment, we analyze equilibrium dynamics of the economy and derive empirical and welfare implications. The model can mimic some stylized facts: (i) a temporary increase in fiscal spending always deteriorates the current account whereas a permanent increase in fiscal spending may have a weaker effect; (ii) permanent productivity shocks deteriorate the current account; and (iii) savings and investment tend to co-move upon macroeconomic shocks. Strong habit persistence causes sluggishness in welfare dynamics. Consequently, a beneficial fiscal policy may have a harmful hangover effect on the future welfare.