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Deep habits, price rigidities and the consumption response to Government spending

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This paper presents the novel implications of introducing price rigidities into a model of good-specific habit formation, for the response of private consumption following a positive government spending shock. With 'deep' habits in demand, the price elasticity of demand rises after the fiscal expansion and it is optimal for the firm to lower the mark-up while increasing production. This in turn raises the demand for labour and the real wage rises. Consequently, agents raise consumption at the expense of leisure and overcome the negative wealth effect of the fiscal shock. We show that increasing price stickiness in a model with deep habits hinders the crowding-in of consumption. If the degree of price stickiness is high enough, consumption is crowded out by government spending. These dynamics are in stark contrast to those in traditional models where price rigidities are known to weaken the crowding-out of consumption.

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Paper provided by Reserve Bank of New Zealand in its series Reserve Bank of New Zealand Discussion Paper Series with number DP2013/03.

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Length: 35 p.
Date of creation: Jan 2013
Date of revision:
Handle: RePEc:nzb:nzbdps:2013/03

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  1. P. Jacob & G. Peersman, 2008. "Dissecting the Dynamics of the US Trade Balance in an Estimated Equilibrium Model," Working Papers of Faculty of Economics and Business Administration, Ghent University, Belgium, Ghent University, Faculty of Economics and Business Administration 08/544, Ghent University, Faculty of Economics and Business Administration.
  2. Punnoose Jacob, 2013. "Deep Habits, Price Rigidities and the Consumption Response to Government Spending," CAMA Working Papers, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University 2013-72, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  3. Morten O. Ravn & Stephanie Schmitt-Grohe & Martín Uribe & Lenno Uuskula, 2008. "Deep Habits and the Dynamic Effects of Monetary Policy Shocks," Economics Working Papers, European University Institute ECO2008/40, European University Institute.
  4. Roland Straub & Gert Peersman, 2006. "Putting the New Keynesian Model to a Test," IMF Working Papers, International Monetary Fund 06/135, International Monetary Fund.
  5. Zubairy, Sarah, 2010. "Deep Habits, Nominal Rigidities and Interest Rate Rules," MPRA Paper 26053, University Library of Munich, Germany.
  6. Frank Smets & Rafael Wouters, 2007. "Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach," American Economic Review, American Economic Association, American Economic Association, vol. 97(3), pages 586-606, June.
  7. Olivier Blanchard & Roberto Perotti, 2002. "An Empirical Characterization Of The Dynamic Effects Of Changes In Government Spending And Taxes On Output," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 117(4), pages 1329-1368, November.
  8. Morten Ravn & Stephanie Schmitt-Grohé & Mart�n Uribe, 2006. "Deep Habits," Review of Economic Studies, Oxford University Press, Oxford University Press, vol. 73(1), pages 195-218.
  9. Cristiano Cantore & Paul Levine & Giovanni Melina & Bo Yang, 2012. "A Fiscal Stimulus with Deep Habits and Optimal Monetary Policy," School of Economics Discussion Papers, School of Economics, University of Surrey 0512, School of Economics, University of Surrey.
  10. Campbell Leith & Ioana Moldovan & Raffaele Rossi, 2008. "Optimal monetary policy in a new Keynesian model with habits in consumption," Working Papers, Business School - Economics, University of Glasgow 2008_30, Business School - Economics, University of Glasgow, revised Dec 2008.
  11. Troy Davig & Eric M. Leeper, 2009. "Monetary-fiscal policy interactions and fiscal stimulus," Research Working Paper, Federal Reserve Bank of Kansas City RWP 09-12, Federal Reserve Bank of Kansas City.
  12. Rotemberg, Julio J, 1982. "Monopolistic Price Adjustment and Aggregate Output," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 49(4), pages 517-31, October.
  13. Campbell Leith & Ioana Moldovan & Raffaele Rossi, 2012. "Online Appendix to "Optimal Monetary Policy in a New Keynesian Model with Habits in Consumption"," Technical Appendices, Review of Economic Dynamics 09-154, Review of Economic Dynamics.
  14. Florin O. Bilbiie, 2011. "Nonseparable Preferences, Frisch Labor Supply, and the Consumption Multiplier of Government Spending: One Solution to a Fiscal Policy Puzzle," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 43(1), pages 221-251, 02.
  15. Sarah Zubairy, 2010. "On Fiscal Multipliers: Estimates from a Medium Scale DSGE Model," Working Papers, Bank of Canada 10-30, Bank of Canada.
  16. Furlanetto, Francesco, 2011. "Fiscal stimulus and the role of wage rigidity," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 35(4), pages 512-527, April.
  17. Cristiano Cantore & Paul Levine & Giovanni Melina, 2011. "A Fiscal Stimulus and Jobless Recovery," School of Economics Discussion Papers, School of Economics, University of Surrey 1111, School of Economics, University of Surrey.
  18. Ravn, Morten O. & Schmitt-Grohé, Stephanie & Uribe, Martín, 2012. "Consumption, government spending, and the real exchange rate," Journal of Monetary Economics, Elsevier, Elsevier, vol. 59(3), pages 215-234.
  19. Linnemann, Ludger & Schabert, Andreas, 2003. " Fiscal Policy in the New Neoclassical Synthesis," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 35(6), pages 911-29, December.
  20. Winkler, Roland & Lewis, Vivien, 2013. "Fiscal Stimulus and the Extensive Margin," Annual Conference 2013 (Duesseldorf): Competition Policy and Regulation in a Global Economic Order, Verein für Socialpolitik / German Economic Association 79947, Verein für Socialpolitik / German Economic Association.
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Cited by:
  1. Cristiano Cantore & Paul Levine & Giovanni Melina & Bo Yang, 2012. "A Fiscal Stimulus with Deep Habits and Optimal Monetary Policy," School of Economics Discussion Papers, School of Economics, University of Surrey 0512, School of Economics, University of Surrey.
  2. Punnoose Jacob, 2013. "Deep Habits, Price Rigidities and the Consumption Response to Government Spending," CAMA Working Papers, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University 2013-72, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  3. B. Verhelst & D. Van Den Poel, 2012. "Deep Habits in Consumption: A Spatial Panel Analysis Using Scanner Data," Working Papers of Faculty of Economics and Business Administration, Ghent University, Belgium, Ghent University, Faculty of Economics and Business Administration 12/823, Ghent University, Faculty of Economics and Business Administration.

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