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Government spending shocks, wealth effects and distortionary taxes

Listed author(s):
  • Cloyne, James S

This paper investigates the transmission mechanism of government spending shocks in an estimated dynamic general equilibrium model. I construct a New Keynesian model with distortionary labour and capital taxes and with references that allow the wealth effect on labour supply to vary in strength. I show that the interaction of these two features crucially affects the response of the economy to a government spending shock. The model's parameters are therefore estimated (including the tax policy rules) for the United States. I show that the estimated model can match the positive empirical response of key variables including output, consumption and the real wage - a challenge for many New Keynesian models. I find that the estimated importance of the wealth effect is small; that sticky prices, variable capital utilisation, investment adjustment costs and habits all play an important role; and that whilst tax rates rise following the shock, their small magnitude crucially reduces the distortions involved.

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File URL: https://mpra.ub.uni-muenchen.de/41689/1/MPRA_paper_41689.pdf
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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 41689.

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Date of creation: 06 Jul 2011
Handle: RePEc:pra:mprapa:41689
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