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How does government spending stimulate consumption?

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  • Murphy, Daniel P.

Abstract

Recent empirical work finds that government spending shocks cause aggregate consumption to increase over the business cycle, contrary to the predictions of Neoclassical and New Keynesian models. This paper proposes a mechanism to account for the consumption increase that builds on the framework of imperfect information in Lucas (1972) and Lorenzoni (2009). In my model, owners of firms targeted by an increase in government spending perceive an increase in their permanent income relative to their future tax liabilities. Owners of firms not targeted remain unaware of the implicit increase in future tax liabilities, causing aggregate consumption to increase. A testable implication of the proposed model is that the value of firms should increase, implying all else equal an increase in aggregate stock returns. This prediction of the model is shown to be consistent with empirical evidence.

Suggested Citation

  • Murphy, Daniel P., 2013. "How does government spending stimulate consumption?," Globalization and Monetary Policy Institute Working Paper 157, Federal Reserve Bank of Dallas.
  • Handle: RePEc:fip:feddgw:157
    Note: Published as: Murphy, Daniel P. (2015), "How Does Government Spending Stimulate Consumption?" Review of Economic Dynamics 18 (3): 551-574.
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    File URL: http://www.dallasfed.org/assets/documents/institute/wpapers/2013/0157.pdf
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    References listed on IDEAS

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    Cited by:

    1. Khalid Khan & Chen FEI & Muhammad Abdul Kamal & Badar Nadeem Ashraf, 2015. "Impact of Government Spending on Private Consumption Using ARDL Approach," Asian Economic and Financial Review, Asian Economic and Social Society, vol. 5(2), pages 239-248, February.
    2. Ricco, Giovanni, 2015. "A new identification of fiscal shocks based on the information flow," Working Paper Series 1813, European Central Bank.

    More about this item

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination

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