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The Effect of Government Spending on Private Consumption: A Puzzle?

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  • Linnemann, Ludger

Abstract

The empirical finding that cyclical changes in government spending tend to be associated with positive responses of private consumption has been interpreted as a challenge for representative agent intertemporal optimizing theories, which usually imply that the negative wealth effect of higher fiscal spending reduces the households' consumption and leisure. The present paper shows that the evidence can be explained by a standard real business cycle type model. With a nonadditively separable utility function and a small intertemporal consumption elasticity, higher fiscal spending can raise consumption and lower investment, as in the data. The nonseparable utility model is shown to imply the same consumption Euler equation as a model with "rule-of-thumb" consumers who mechanically spend their income.

Suggested Citation

  • Linnemann, Ludger, 2006. "The Effect of Government Spending on Private Consumption: A Puzzle?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(7), pages 1715-1735, October.
    • Handle: RePEc:mcb:jmoncb:v:38:y:2006:i:7:p:1715-1735
    DOI: 10.1353/mcb.2006.0094
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