One of the most prominent and consistent findings of the recent empirical literature on fiscal policy is that investment expenditure is crowded out by public spending in the short run. In this contribution, we address this empirical fact using a dynamic general equilibrium model and show that the introduction of habit-forming behavior plays a major role in accommodating the observed negative relationship between investment and government expenditure. Our numerical experiments point out the role of consumption inertia in determining the reactions of the open economy: as habit persistence gets stronger, fiscal expansion crowds out real consumption by a smaller amount and investment by a larger one, while the current account enters into a greater deficit.
