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Why Does Private Consumption Rise After a Government Spending Shock?

  • Nooman Rebei
  • Hafedh Bouakez

Recent empirical evidence suggests that private consumption is crowded-in by government spending. This outcome violates existing macroeconomic theory, according to which the negative wealth effect brought about by a rise in public expenditure should decrease consumption. In this paper, we develop a simple real business cycle model where preferences depend on private and public spending, and households are habit forming. The model is estimated by the minimum-distance and the maximum-likelihood methods using U.S. data. Estimation results indicate a strong Edgeworth complementarity between private and public spending. This feature enables the model to generate a positive response of consumption following a government spending shock. In addition, the impulse-response functions generated by the estimated model mimic closely those obtained from a benchmark vector autoregression.

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Paper provided by Econometric Society in its series Econometric Society 2004 North American Summer Meetings with number 417.

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Date of creation: 11 Aug 2004
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Handle: RePEc:ecm:nasm04:417
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