Government Spending in an Economy with Habit Formation

This paper examines the effects of a permanent increase in government spending in an economy with habit formation. For this purpose we apply the continuous-time version of the utility function originally suggested by Abel (1990) to the frame-work of the modified Ramsey model a la Djajic (1987) and Ihori (1990). We show that the effects of a permanent increase in government spending already obtained in the modified Ramsey model are still robust in an economy with habit formation. We also show that the interaction between the inverse of intertemporal elasticity of substitution and the habit parameter is an important factor for the shadow prices of capital and habit stocks in the long-run