Habit Formation in an Interdependent World Economy

In a two-country world economy, consumption-habit dynamics in one country are affected, due to endogenous interest rate adjustments, by the other country's habits and preferences. External indebtedness depends crucially on international differences in habit-adjusted net output less habitual living standard. Interest rate adjustments enlarge the consumption impact of an income shock. Consistently with the empirical facts, the habit parameter of a large country, therefore, would be underestimated, and the current account volatility overestimated, if estimated using a small-country model. An increase in fiscal spending in one country can benefit the country and harm the neighbor due to intertemporal terms-of-trade effects.

Habit Formation in an Interdependent World Economy

ISER discussion paperSeptember 2004 Revised July 200

Heterogeneous habits and the transfer paradox

By using a two-country model with habit-forming consumers, this paper shows that the transfer paradox can take place in the free-trade, dynamically-stable world economy. When the debtor is more habituated to consumption than the creditor, an income transfer from the creditor to the debtor raises the interest rate in transition through changes in time preference. With sufficiently low elasticities of intertemporal substitution and/or sufficiently large stock of the creditor's assets, the intertemporal terms of trade effect immiserizes the recipient and enriches the donor. Although the transfer paradox occurs only when the international bond market is 'unstable' with respect to an ad hoc Walrasian adjustment process, the equilibrium dynamics are stable in the usual sense: given that the economy is always in the rational expectation equilibrium, the transfer paradox generically occurs

Global habits, habit differentials, and international macroeconomic adjustment to income shocks

In a two-country model with habit formation, we focus on interdependent macroeconomic adjustments to global and country-specific income shocks.Global habits and habit differentials play key roles in the global equilibrium dynamics, possibly nonmonotonic, and in the determination of international asset distribution. A country's steady-state holdings of net external assets rely on (i) weighted income difference in excess of habit differentials and (ii) global income in excess of global habits. Local income shocks have greater effects on the international asset distribution than global income shocks. With habit formation, positive income shocks lower the world interest rate, thereby harming the creditor country and benefitting the debtor country due to the intertemporal terms-of-trade effect. In contrast to the case of trade theory, this intertemporal immiserizing growth effect is more likely to be caused by global income shocks than by country-specific income shocks

Exchange Rate and Current Account Dynamics with Habits over Consumption and Money Holdings

Copyright © 2013 Ichiro Gombi, Shinsuke Ikeda. This is an open access article distributed under the Creative Commons Attribution License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited. Incorporating two independent habits over consumption and money holdings into a small country model, we examine the adjustment dynamics of the current account and the exchange rate to expansionary monetary and fiscal shocks under two alternative policy regimes: (1) the endogenous income transfer regime; and (2) the endogenous fiscal spending regime. In response to the shocks under regime (1), the exchange rate depreciates on impact and in the long run whereas it appreciates (depreciates) in transition if preferences for real money balances exhibit distant (adjacent) complementarity. Under regime (2), the consumption habits and the monetary habits jointly generate possibly non-monotonic current account dynamics. An induced increase in fiscal spending in regime (2) can generate a current account surplus in the case where the monetary habits exhibit strong distant complementarity