This paper revisits the macroeconomic effects of government consumption in the neoclassical growth model augmented with idiosyncratic investment (or entrepreneurial) risk. Under complete markets, a permanent increase in government consumption has no long-run effect on the interest rate, the capital-labor ratio, and labor productivity, while it increases work hours due to the familiar negative wealth effect. These results are upset once we allow for incomplete markets. The very same negative wealth effect now causes a reduction in risk taking and investment. This in turn leads to a lower risk-free rate and, under certain conditions, also to a lower capital-labor ratio, lower productivity and lower wages.
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
13136.
Length: Date of creation: May 2007 Date of revision: Handle: RePEc:nbr:nberwo:13136
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Find related papers by JEL classification: E13 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Neoclassical E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook H3 - Public Economics - - Fiscal Policies and Behavior of Economic Agents
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