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This paper develops a new open economy macroeconomics model by allowing for habit formation in labor supply. The main findings of our analysis are that 1) an increase in the importance of working habits strengthens the effect of monetary policy shocks on relative consumption, weakens on change in the equilibrium exchange rate , and 2) an increase in the importance of working habits strengthens the response of relative consumption and the equilibrium exchange rate change to fiscal policy shocks.

Similar to consumption habit (Abel [

No study has so far attempted to introduce the hypothesis of working habits into the new open economy macro-economics (NOEM) paradigm, so the main innovation in our exercise is that we elaborate on OR model with working habits. In recent years, NOEM models of type developed by Obstfeld and Rogoff [

As the assumption of Faria and Miguela [

For brevity, we restrict the attention to the question of how the strength of habit formation affects the response of both relative consumption and the exchange rate to monetary and fiscal policy, particularly in comparison with those illustrated by the benchmark OR model, in which habit-forming labor supply is ignored.

The remainder of this paper is organized as follows. In Section 2, we outline the features of the dynamic optimizing model. In Section 3, we present model results. In Section 4, we make a conclusion.

The world is populated by a continuum of infinitely-lived households. Every agent being both household and firm is indexed by

In this model with habit forming-labor supply, the utility of a person

where

The domestic agent’s utility function can be interpreted as

where

Subject to the budget constraint

where the only asset they trade is a nominal bond denominated in the currency of the domestic country, that we denote with

Let

where

where

Solving the optimization problem presented above yields the following first-order conditions:

where Equation (3) is a standard Euler equation for optimal consumption. Equation (4) equates the marginal utility of real balances to the opportunity cost in terms of consumption. Deviating from standard labor-leisure trade-off equation, Equation (5) equates the marginal disutility of labor with the marginal positive utility of the real wage plus of a stock of working habits, thereafter called as labor-leisure with working-habit trade-off equation.

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It is assumed that there is government spending can be financed through lump-sum taxes or seignorage. The government budget constraint, expressed in per-capita terms, is given by

For simplicity it is assumed that output is equal to labor input. Thus

where

where

ities, the profit maximization process would imply that the price of each differentiated good is given by a simple mark-up over wages, according to the equation

We consider an initial steady state where net foreign assets are zero for both countries

It is easy to verify the fact that

We also introduce short-run nominal rigidities in the form of one period preset price in the currency of the producer as in OR model. In terms of notation, in the log-linearized version of the model, we will denote short- run variables using tildes, and long-run variables using hats. In the short run, nominal producer prices

In order to solve our model, we should resort to log-linearization. Equations (11)-(20) summarize the log-li- nearization of the model around the initial steady state presented above.

Due to the symmetry of the model, only the domestic equations, the PPP equation, and the world goods market equilibrium equation are reported. Equations (11)-(20) are log-linearized versions of price index, the Euler equation, the short- and long-run money demand equations, the labor-leisure with working-habit trade-off equation, the demand equation, the short-and long run current account equations, the PPP equation and the world goods market equilibrium condition.

Equations (11)-(20) note:

In this section, we consider macroeconomic effects of monetary and fiscal policy in the formation of working habits OR model.

Following Obstfeld and Rogoff’s graphical analysis, we derive the following MM and GG schedules, respectively:

where

To simplify, we look at monetary and fiscal shocks separately, thereby assuming temporarily that

The effects of expansionary monetary shocks (i.e.^{1}, the new equilibrium in the case of OR model with working habits will arrive at the new intersection point EQ2 compared to EQ1 in the case of the benchmark OR model without working habits (i.e.

The intuition for the result that domestic consumption increases more compared to the foreign consumption is that the higher

Furthermore, the lower magnitude of domestic depreciation is to restore equilibrium in the money market due to the more increase in relative consumption caused by the presence of working habits.

Now, we restrict our attention to government spending shocks, in analogy to the above monetary shocks case,

thus abstracting from monetary changes by assuming that

Instead of Equation (21), the expression

describes the new MM schedule, which passes through the origin in

As we mention above, the higher

Intuitively, domestic residents are paying for the government spending more, but a government’s spending equally falls on home and foreign goods, which doesn’t exist home-product bias, so home country people consume less with respect to its foreign. When there are habit formations for labor supply, the habit formations enhance the mechanism due to our parameters setup. Because the relative consumption change lowers the relative demand for home money, nominal exchange rate rises more.

In this paper we have analyzed the impact of introducing habit formation in labor supply in OR model and compared its outcome in terms of monetary policy and fiscal policy with a model in the absence of habit formation. We make some progress towards a model that meets the benchmark OR model. It does so by including a particular form of non-time-separability in the utility function, namely “habit formation”, or the assessment by

households of utility relative to a habit level of labor. Our results are important since in the future they help to explain differences in the long-run performance of economies with different social incentives towards work owing to cultural, religious and economic organization factors as evidenced in the empirical literature.

Finally, we just restrict our attention on theoretical aspects of the NOEM model with habit formation of labor supply, so whether the results of this paper are consistent with empirical evidence or not put in the future research.

The research work was supported by the MOE (Ministry of Education in China) Project of Humanities and Social Sciences for the Youth (Project No.14YJC790129), China Postdoctoral Science Foundation (2014 M550205).

YunqingWang,QianwenLiu,BayiGuan,XinyuSui, (2015) The New Open Economy Macroeconomics of Working Habits. Theoretical Economics Letters,05,125-131. doi: 10.4236/tel.2015.51017

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