Habit Formation And The Transfer Paradox

Using a two‐country model with habit‐forming consumers, we show that the transfer paradox can occur in a free‐trade, dynamically stable economy. When the debtor is more in the habit of consuming than the creditor, an income transfer from the creditor to the debtor raises the interest rate in transition through changes in time preference. With sufficiently low elasticities of intertemporal substitution and/or sufficiently large stocks of the creditor's assets, the intertemporal terms‐of‐trade effect immiserizes the recipient and enriches the donor. This possibility cannot be excluded by the correspondence principle (à la Burmeister and Long) as the dynamics are saddlepoint‐stable.