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Assessing the Impact of a Change in the Composition of Public Spending; A DSGE Approach

  • Ivan Tchakarov
  • Roland Straub

Despite intense calls for safeguarding public investment in Europe, public investment expenditure, when measured in relation to GDP, has steadily fallen in the last three decades, evoking fears that economic activity may be correspondingly negatively affected. At the same time, however, public consumption in the EU-12 countries has trended up. In this paper, we provide a macroeconomic assessment of the observed change in the composition of public spending in the euro area in a medium-scale two-country dynamic stochastic general equilibrium (DSGE) model. First, we identify the channels through which both temporary and permanent public investment shocks generate larger fiscal multipliers than exogenous increases in public consumption. Second, we quantify the negative impact of a change in fiscal stance, characterized by a permanent rise in public consumption and a permanent fall in public investment, keeping the overall level of public spending constant. The key message of the paper is that calls for reversing the observed trend in the composition of public spending are well justified.

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Paper provided by International Monetary Fund in its series IMF Working Papers with number 07/168.

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Length: 47
Date of creation: 01 Jul 2007
Date of revision:
Handle: RePEc:imf:imfwpa:07/168
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  1. Günter Coenen & Roland Straub, 2005. "Does Government Spending Crowd in Private Consumption? Theory and Empirical Evidence for the Euro Area," International Finance, Wiley Blackwell, vol. 8(3), pages 435-470, December.
  2. David Aschauer, 1988. "Is public expenditure productive?," Staff Memoranda 88-7, Federal Reserve Bank of Chicago.
  3. David Alan Aschauer, 1989. "Public investment and productivity growth in the Group of Seven," Economic Perspectives, Federal Reserve Bank of Chicago, issue Sep, pages 17-25.
  4. J. Galí & D. López-Salido & J. Vallés, 2003. "Understanding the effects of government spending on consumption," Proceedings, Board of Governors of the Federal Reserve System (U.S.).
  5. Valila, Timo & Mehrotra, Aaron, 2005. "Evolution And Determinants Of Public Investment In Europe," Economic and Financial Reports 2005/1, European Investment Bank, Economics Department.
  6. Günter Coenen & Roland Straub, 2005. "Does Government Spending Crowd In Private Consumption? Theory and Empirical Evidence for the Euro Area," IMF Working Papers 05/159, International Monetary Fund.
  7. Romp, Ward & de Haan, Jakob, 2005. "Public capital and economic growth: a critical survey," EIB Papers 2/2005, European Investment Bank, Economics Department.
  8. Jakob Haan & Jan Sturm & Bernd Sikken, 1996. "Government capital formation: Explaining the decline," Review of World Economics (Weltwirtschaftliches Archiv), Springer, vol. 132(1), pages 55-74, March.
  9. Roberto Perotti, 2004. "Public investment: another (different) look," Working Papers 277, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  10. Coenen, Günter & McAdam, Peter & Straub, Roland, 2008. "Tax reform and labour-market performance in the euro area: A simulation-based analysis using the New Area-Wide Model," Journal of Economic Dynamics and Control, Elsevier, vol. 32(8), pages 2543-2583, August.
  11. Evi Pappa, 2005. "New Keynesian or RBC Transmission? The Effects of Fiscal Policy in Labor Markets," Working Papers 293, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
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