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How does government spending stimulate consumption?

  • Murphy, Daniel P.

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.

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File URL: http://www.dallasfed.org/assets/documents/institute/wpapers/2013/0157.pdf
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Paper provided by Federal Reserve Bank of Dallas in its series Globalization and Monetary Policy Institute Working Paper with number 157.

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Length: 41 pages
Date of creation: 2013
Date of revision:
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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  1. Gonçalves, Sílvia & KILIAN, Lutz, 2003. "Bootstrapping Autoregressions with Conditional Heteroskedasticity of Unknown Form," Cahiers de recherche 01-2003, Centre interuniversitaire de recherche en économie quantitative, CIREQ.
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  11. Christopher J. Nekarda & Valerie A. Ramey, 2013. "The Cyclical Behavior of the Price-Cost Markup," NBER Working Papers 19099, National Bureau of Economic Research, Inc.
  12. JonasD.M. Fisher & Ryan Peters, 2010. "Using Stock Returns to Identify Government Spending Shocks," Economic Journal, Royal Economic Society, vol. 120(544), pages 414-436, 05.
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  17. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
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