Why Does Private Consumption Rise After A Government Spending Shock?

Abstract: Some recent empirical evidence suggests that private consumption is crowded-in by government spending. This outcome violates neoclassical macroeconomic theory, according to which the negative wealth effect brought about by a rise in public expenditure should decrease consumption. In this paper, we develop a simple real business cycle model where preferences depend on private and public spending, and households are habit forming. The model is estimated by the maximum-likelihood method using U.S. data. Estimation results indicate a strong Edgeworth complementarity between private and public spending. This feature enables the model to generate a positive response of consumption following a government spending shock. In addition, the impulse-response functions generated by the estimated model are generally consistent with those obtained from a benchmark vector autoregression.

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