The Crowding-Out Effect and Habit Persistence in Consumption

This paper investigates the dynamic and steady-state effects of an expansionary budget policy within a two-good semi-small open economy with habit formation. In line with empirical evidence, investment expenditure is crowded-out by public purchases due to consumption inertia and the open economy experiences a short-run current account deficit triggered by a strong negative savings flow. According to numerical experiments, we find that a fiscal expansion crowds-out real consumption by less and investment expenditure by more in the short-run as habit persistence gets stronger. In addition, the country experiences a greater current account deficit over the transition and smaller overall welfare losses as consumption inertia gets larger