HABIT FORMATION IN AN INTERDEPENDENT WORLD ECONOMY

Abstract

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