Deep Habits, Price Rigidities and the Consumption Response to Government Spending

36 Pages Posted: 9 Nov 2013 Last revised: 20 Jan 2014

Date Written: November 1, 2013

Abstract

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 labor 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.

Keywords: Deep Habits, Sticky Prices, Government Spending, Crowding-out

JEL Classification: E21, E31, E62

Suggested Citation

Jacob, Punnoose, Deep Habits, Price Rigidities and the Consumption Response to Government Spending (November 1, 2013). CAMA Working Paper No. 72/2013, Available at SSRN: https://ssrn.com/abstract=2351642 or http://dx.doi.org/10.2139/ssrn.2351642

Punnoose Jacob (Contact Author)

Reserve Bank of New Zealand ( email )

2 The Terrace
PO Box 2498
Wellington, 6140
New Zealand

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
18
Abstract Views
311
PlumX Metrics