Deep habits and financing of government expenditure growth
M. Andreyev
This paper uses a general equilibrium model for an open export-oriented economy to address two key issues.
The first issue is the investigation of the mechanism of deep habits in an exporting economy. Habits refer to consumers’ tendency to maintain a consumption level similar to previous periods, while deep habits indicate a tendency related to each individual good rather than to consumption as a whole.
The study finds that deep habits lead to smaller shifts in the household demand curve, attributable to households’ reluctance to deviate from historical consumption levels. These less pronounced shifts in the demand curve result in lower volatility of such key economic volume indicators as output and consumption, while inflation as a price indicator exhibits higher volatility. This increased volatility arises from the combination of two effects: one related to the movement of the demand curve itself and the other stemming from changes in economic price indicators following shocks to the economy (e.g. exchange rate fluctuations in the case of a terms-of-trade shock or price changes due to increased government consumption in the case of a government spending shock).
The second issue is the comparison of options for financing increased government spending. We show that a long-lasting government spending shock (under all the financing scenarios considered but one) generates a crowding-out effect on consumption and output, whereas a temporary shock results in an accumulation effect. The difference in the impact of a long‑lasting and a temporary spending shock is explained by the dynamics of household disposable income. If the government spending shock is temporary, the production sector responds with a sharp, short-term increase in labour demand, leading to higher household income and consumption, which temporarily stimulates output growth. In contrast, with a long-lasting government spending shock, the production sector shifts towards capital investment, while labour income grows only slightly. If, at the same time, household disposable income decreases (due to higher taxes or the purchase of government bonds), consumer demand and thus output drop, neutralising the stimulating effect of government demand.
The study shows that short- and medium-term increases in government consumption can be achieved through various financing options. However, almost all the scenarios result in a medium-term increase in government consumption at the expense of long-term consumption, driven by the assumption (adopted in our study) that the government aims to return debt levels to their original state. Based on two criteria, public welfare and government consumption in the long term, the most preferred financing option for growth in expenditure is external financing, either through a national wealth fund invested in foreign assets or the external debt market. The preference for external financing can be explained, first, by a stronger domestic currency during periods of increased government spending, which reduces the cost of imports as a production factor, and second, by non-declining household disposable income. Both factors keep household consumption and output in positive territory during periods of increased government consumption. The presence or absence of deep habits influences the quantitative indicators of the options for financing government consumption growth, yet does not affect the ranking of these options.