Habit formation, adjustment costs, and international transmission of fiscal policy

The paper studies the effects of fiscal policy in an integrated world economy. The setup is one with habit-forming endogenous rates of time preference and adjustment costs in investment. Most of the predictions of the model are in line with the recent empirical literature on fiscal policy. For instance, in response to a balanced fiscal expansion, we obtain positive long-run output multipliers, long-run increases in employment, short- and medium-run increases in wages and decreases in investment. Our results suggest that short-run government spending multipliers are smaller than tax multipliers. Most importantly, we show that the model can generate positive short- and medium-run consumption responses to a positive fiscal shock. This is relevant as negative consumption responses are considered to be one of the main challenges facing neo-classical models of fiscal policy.