Deep habits and financing of government expenditure growth

This paper uses a stochastic general equilibrium model for a small open export-oriented economy to address two key issues. First, it analyses the impact of deep habits in such an economy. Habits refer to consumers’ tendency to maintain a consumption level similar to previous periods, while deep habits indicate a tendency related to each consumed good rather than just the overall consumption level. We present a model in which the formulation of deep habits differs from the conventional one, taking into account imports in consumption. Second, we compare different financing options for growth in government spending. The role of deep habits in response to economic shocks is reflected in the dampening of shifts in the household demand curve. The paper is the first to show that deep habits lead to lower volatility in output and consumption and to higher volatility in inflation. It also demonstrates that a long-lasting government spending shock results in a crowding-out effect on consumption and output, while a temporary shock leads to an accumulation effect. The medium-term increase in government spending (and government consumption) examined in this study, due to the subsequent need to balance public debt levels, results in decreasing government consumption in the long term. Based on two criteria (maximising welfare and government consumption in the long term), the most preferred financing options for growth in expenditure are the use of a national fund invested in foreign assets or the external debt market. A key innovation of the study is the application of the concept of deep habits to an exporting economy where imports play a significant role in consumer demand; the differentiation between temporary and long-lasting government spending shocks; and the analysis of various financing options for public spending growth, which, as shown, influences the manifestation of either the accumulation or crowding-out effect.