Heterogeneous Habits and the Transfer Paradox

By using a two-country model with habit-forming consumers, this paper shows that the transfer paradox can take place in the free-trade, dynamically-stable world economy. When the debtor is more habituated to consumption than the creditor, an income transfer from the creditor to the debtor raises the interest rate in transition through changes in time preference. With su¢ciently low elasticities of intertemporal substitution and/or su¢ciently large stock of the creditor's assets, the intertemporal terms of trade eÛect immiserizes the recipient and enriches the donor. Although the transfer paradox occurs only when the international bond market is "unstable" with respect to an ad hoc Walrasian adjustment process, the equilibrium dynamics are stable in the usual sense: given that the economy is always in the rational expectation equilibrium, the transfer paradox generically occurs.