Confidence and the Transmission of Government Spending Shocks

There seems to be a widespread belief among economists, policy-makers, and members of the media that the “confidence” of households and firms is a critical component of the transmission of fiscal policy shocks into economic activity. In this paper we take this proposition to the data. We use standard restrictions from the literature to identify government spending shocks in VARs augmented to include empirical measures of consumer or business confidence. We also estimate non-linear specifications to allow for differential impacts of government spending in normal times versus recessions. Our first result is that in normal times confidence does not react significantly in response to unexpected increases in government spending; during recessions it rises. In addition, the spending multiplier is much larger in recessions than in normal times. We then construct counterfactual impulse responses in which the response of confidence to government spending shocks is “shut down”. Comparing the actual and counterfactual responses of output allows us to determine the importance of confidence as a transmission mechanism of policy. We find as our second result that confidence is irrelevant in the transmission of government spending shocks to output in normal times, but is very important during downturns. Third, we provide some evidence that this is because spending shocks during downturns predict future productivity rises through persistent increases in government investment relative to government consumption.