DP8035 Habit Formation and Fiscal Transmission in Open Economies

Author(s): Olivier Cardi, Gernot Müller
Publication Date: October 2010
Keyword(s): Current Account, Fiscal Policy, Habit formation, Investment
JEL(s): E32, E62, F41
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8035

In this paper we analyze the ability of an open economy version of the neoclassical model to account for the time-series evidence on fiscal policy transmission. In a first step, we identify government spending shocks within a vector autoregression model. We find that i) government spending increases output and induces a simultaneous decline of investment and the current account, but does not affect consumption; ii) the responses of output and investment are smaller in more open economies, while current account deficits tend to be larger. We find the predictions of the model to be broadly in line with the evidence, once we allow for habit formation in consumption. Specifically, habits are crucial for government spending to induce a simultaneous decline in investment and the current account.