Global Versus Country Specific Income Shocks with Relative and Global Habits

In a two-country world economy with habit formation, we examine the effects of global and country-specific income shocks on each country. The global economic dynamics are driven by global habits and individual countries' relative habits. A country's net external asset holdings relay on weighted income difference in excess of relative habits and global income in excess of global habits. Global income shocks have smaller effects on the international asset distribution than local income shocks, if the resulting aggregate output changes are the same between the two shocks. With habit formation, positive income shocks lower the world interest rate, thereby harming the creditor country and benefitting the debtor country due to the intertemporal terms-of-trade effect. In contrast to the case of trade theory, this intertemporal immiserizing growth is more likely to be brought about by global income shocks than by country-specific income shocks.
JEL Classification Numbers: F41, D90.
Keywords: Habit formation, relative habit, two country, global shock, country-specific shock, immiserizing growth.