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Explaining the Effects of Government Spending Shocks on Consumption and the Real Exchange Rate

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Author Info
Morten O. Ravn
Stephanie Schmitt-Grohe
Martin Uribe

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Abstract

Using panel structural VAR analysis and quarterly data from four industrialized countries, we document that an increase in government purchases leads to an expansion in output and private consumption, a deterioration in the trade balance, and a depreciation of the real exchange rate (i.e., a decrease in the domestic CPI relative to the exchange-rate adjusted foreign CPI). We propose an explanation for these observed effects based on the deep habit mechanism. We estimate the key parameters of the deep-habit model employing a limited information approach. The predictions of the estimated deep-habit model fit well the observed responses of output, consumption, the trade balance, and the real exchange rate to an unanticipated government spending shock. In addition, the deep-habit model predicts that in response to an anticipated increase in government spending consumption and wages fail to increase on impact, which is consistent with the empirical evidence stemming from the narrative identification approach. In this way, the deep-habit model reconciles the findings of the SVAR and narrative literatures on the effects of government spending shocks.

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Paper provided by European University Institute in its series Economics Working Papers with number ECO2007/23.

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Date of creation: 2007
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Handle: RePEc:eui:euiwps:eco2007/23

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Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Morten Ravn & Stephanie Schmitt-Grohe & Martin Uribe, 2006. "Deep Habits," Review of Economic Studies, Blackwell Publishing, vol. 73(1), pages 195-218, 01. [Downloadable!] (restricted)
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  2. Burnside, Craig & Eichenbaum, Martin & Fisher, Jonas D. M., 2004. "Fiscal shocks and their consequences," Journal of Economic Theory, Elsevier, vol. 115(1), pages 89-117, March. [Downloadable!] (restricted)
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  3. Froot, Kenneth A & Klemperer, Paul D, 1989. "Exchange Rate Pass-Through When Market Share Matters," American Economic Review, American Economic Association, vol. 79(4), pages 637-54, September. [Downloadable!] (restricted)
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  4. Olivier Blanchard & Roberto Perotti, 2002. "An Empirical Characterization Of The Dynamic Effects Of Changes In Government Spending And Taxes On Output," The Quarterly Journal of Economics, MIT Press, vol. 117(4), pages 1329-1368, November. [Downloadable!] (restricted)
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  5. Fatás, Antonio & Mihov, Ilian, 2001. "The Effects of Fiscal Policy on Consumption and Employment: Theory and Evidence," CEPR Discussion Papers 2760, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  6. Jordi Galí & J. David López-Salido & Javier Vallés, 2007. "Understanding the Effects of Government Spending on Consumption," Journal of the European Economic Association, MIT Press, vol. 5(1), pages 227-270, 03. [Downloadable!] (restricted)
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  7. Martin Eichenbaum & Jonas Fisher, 2004. "Fiscal Policy in the Aftermath of 9/11," NBER Working Papers 10430, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  8. 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. [Downloadable!] (restricted)
  9. Ramey, Valerie A. & Shapiro, Matthew D., 1998. "Costly capital reallocation and the effects of government spending," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 48(1), pages 145-194, June. [Downloadable!] (restricted)
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  10. Nickell, Stephen J, 1981. "Biases in Dynamic Models with Fixed Effects," Econometrica, Econometric Society, vol. 49(6), pages 1417-26, November. [Downloadable!] (restricted)
  11. Giancarlo Corsetti & Gernot J. Müller, 2006. "Twin deficits: squaring theory, evidence and common sense," Economic Policy, CEPR, CES, MSH, vol. 21(48), pages 597-638, October. [Downloadable!] (restricted)
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  12. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April. [Downloadable!] (restricted)
  13. Schmitt-Grohe, Stephanie & Uribe, Martin, 2004. "Solving dynamic general equilibrium models using a second-order approximation to the policy function," Journal of Economic Dynamics and Control, Elsevier, vol. 28(4), pages 755-775, January. [Downloadable!] (restricted)
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  14. Rotemberg, Julio J & Woodford, Michael, 1992. "Oligopolistic Pricing and the Effects of Aggregate Demand on Economic Activity," Journal of Political Economy, University of Chicago Press, vol. 100(6), pages 1153-1207, December. [Downloadable!] (restricted)
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  15. Dr. Peter Kenning & Hilke Plassmann, 2004. "NeuroEconomics," Experimental 0412005, EconWPA. [Downloadable!]
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Alexander Kriwoluzky, 2009. "Matching Theory and Data: Bayesian Vector Autoregression and Dynamic Stochastic General Equilibrium Models," Economics Working Papers ECO2009/29, European University Institute. [Downloadable!]
    Other versions:
  2. Maher Hasan & Jemma Dridi, 2008. "The Impact of Oil-Related Income on the Equilibrium Real Exchange Rate in Syria," IMF Working Papers 08/196, International Monetary Fund. [Downloadable!]
  3. Ravn, Morten O. & Schmitt-Grohé, Stephanie & Uribe, Martín & Uusküla, Lenno, 2009. "Deep Habits and the Dynamic Effects of Monetary Policy Shocks," CEPR Discussion Papers 7128, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  4. Agustín S. Bénétrix, 2009. "Fiscal Shocks and Real Wages," The Institute for International Integration Studies Discussion Paper Series iiisdp288, IIIS. [Downloadable!]
  5. Agustin S. Benetrix, IIIS, Trinity College Dublin. Philip R. Lane, IIIS, Trinity College Dublin, 2009. "Fiscal Shocks and The Sectoral Composition of Output," The Institute for International Integration Studies Discussion Paper Series iiisdp294, IIIS. [Downloadable!]
  6. Ethan Ilzetzki & Carlos A. Vegh, 2008. "Procyclical Fiscal Policy in Developing Countries: Truth or Fiction?," NBER Working Papers 14191, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  7. Schmitt-Grohé, Stephanie & Uribe, Martín, 2009. "What’s News in Business Cycles," CEPR Discussion Papers 7201, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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