Habit formation and the government spending multiplier

This paper explores the impact of habit formation on government spending multipliers (GSMs) within a New Keynesian framework, challenging the widely held belief that GSMs are significantly larger when nominal interest rates are low. We present a novel channel that affects the size of GSM by introducing deep habit preferences, which include consumption habits at the variety level. During periods of persistently low nominal interest rates, deep habits result in more moderate GSM levels, albeit still above 1. Furthermore, deep habits reduce the gap in GSM sizes between the constrained regime, in which 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 emphasizes the importance of habit formation in understanding GSM mechanisms and contributes to the discussion of fiscal policy effectiveness in a low nominal interest rate environment.