Government Spending Shocks and Private Activity: The Role of Sentiments

This paper studies the dynamic effects of the fiscal policy shock on private activity using an array of vector autoregressive models for the post-war U.S. data. We are particularly interested in the role of consumer sentiment in the transmission of the government spending shock. Our major findings are as follows. Private spending fails to rise persistently in response to positive spending shocks, while they exhibit persistent and significant increases when the sentiment shock occurs. Employment and real wages in the private sector also respond significantly positively only to the sentiment shock. The government spending shock generates consumer pessimism, resulting in subsequent decreases in private activity, weakening the effectiveness of the fiscal policy. We further corroborate our claims via counterfactual simulation exercises and nonlinear state-dependent VAR model estimations.