Habit Formation and the Government Spending Multiplier

This paper explores the influence of habit formation on government spending multipliers (GSM) within a New Keynesian framework, challenging the widely accepted belief that GSMs are significantly large when nominal interest rates are low. By introducing deep habit preferences, which include consumption habits at the variety level, we present a novel channel that affects the size of GSM. Our findings indicate that deep habits result in more moderate GSM levels, albeit still above one, during periods of persistently low nominal interest rates. Moreover, deep habits lessen the difference between GSM sizes in the constrained regime, where the nominal interest rate is fixed at the effective lower bound, and the conventional regime, which is characterized by an endogenous Taylor-type nominal interest rate rule. This study underscores the importance of habit formation in understanding GSM mechanisms and enriches the discourse on fiscal policy effectiveness in a low nominal interest rate environment.