ISER discussion paperSeptember 2004 Revised July 200

Gombi, Ichiro

Ikeda, Shinsuke

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.ISER discussion paperSeptember 2004 Revised July 200

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Habit Formation in an Interdependent World Economy

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Habit Formation in an Interdependent World Economy

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