Cyclical effects of the composition of government purchases

This paper constructs a general equilibrium model with monopolistically competitive firms and endogenous markups where government spending consists of both consumption and investment goods. It is shown that when markups are countercyclical, an increase in the share of investment goods in total public expenditure, raises output, employment,and capital stock in the long-run leading to increases in welfare and productivity. However, this also raises the short run cyclical variability of the economy. In particular, variance of output and employment arising from technological and aggregate demand shocks increase as the long run share of government investment goes up implying a trade-off between greater long-run efficiency and higher short-run volatility. We apply our methodology to the postwar US economy and other OECD countries.