How does government spending stimulate consumption?
Abstract: Recent empirical work finds that government spending shocks cause aggregate consumption to increase over the business cycle, contrary to the predictions of Neoclassical and New Keynesian models. This paper proposes a mechanism to account for the consumption increase that builds on the framework of imperfect information in Lucas (1972) and Lorenzoni (2009). In my model, owners of firms targeted by an increase in government spending perceive an increase in their permanent income relative to their future tax liabilities. Owners of firms not targeted remain unaware of the implicit increase in future tax liabilities, causing aggregate consumption to increase. A testable implication of the proposed model is that the value of firms should increase, implying all else equal an increase in aggregate stock returns. This prediction of the model is shown to be consistent with empirical evidence.
File(s): File format is application/pdf http://www.dallasfed.org/assets/documents/institute/wpapers/2013/0157.pdf
Provider: Federal Reserve Bank of Dallas
Part of Series: Globalization Institute Working Papers
Publication Date: 2013
Pages: 41 pages
Note: Published as: Murphy, Daniel P. (2015), "How Does Government Spending Stimulate Consumption?" Review of Economic Dynamics 18 (3): 551-574.