Intergenerational Habits, Fiscal Policy, and Welfare

Abstract The present paper explores the fiscal policy implications of intergenerational habit formation in a Blanchard overlapping generations small open economy model. Three main conclusions emerge. (1) When individuals are finitely lived and have habits which they pass on to their descendants, the dynamic response of a small open economy to shocks exhibits sluggishness in consumption in the short run and may display damped cycles in the long run. (2) With habits, optimal fiscal policy takes the form of a social insurance scheme, allowing present and unborn cohorts to share in the consequences of macroeconomic shocks. In contrast, in an economy devoid of habits, the optimal fiscal response to a permanent shock is a one time abrupt adjustment, whereby the present generations bear the entire burden of the shock. (3) If habits exist but policy is conducted as though habits did not exist, the welfare losses for society can be substantial.