Abstract
We analyze the current account dynamics for a small country model with habit-forming consumers and costly investment. The model has several empirical and policy implications. (i) It is consistent with stylized facts regarding the effects of productivity shocks and increases in fiscal spending and regarding the savings–investment co-movement. (ii) The long-run effect of a temporary shock on net foreign assets is often opposite to that of a permanent shock. (iii) Under strong habit persistence, the welfare dynamics are sluggish, so that a beneficial tax-financed fiscal policy may have a harmful hangover effect on welfare.
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