Macroeconomic policy, current accounts, and exchange rate dynamics with habit formation

By incorporating habits over consumption and over money holdings into a small country model, we examine the dynamic adjustment of the current account and the exchange rate to monetary and fiscal policies in two alternative policy regimes: (i) the endogenous income transfer regime; and (ii) the endogenous fiscal spending regime. In response to the policies, the exchange rate depreciates on impact and in the long run whereas one depreciates (appreciates) in transition if preferences for real money balances exhibit adjacent (distant) complementarity. In regime (ii), the habits over consumption and real money balances jointly generate possibly non-monotonic current account dynamics. An induced increase in fiscal spending can cause current account surplus under strong distant complementarity of real money balances.