Government Purchases Over the Business Cycle: the Role of Heterogeneity and Wealth Bias in Political Decision Making

This paper sets up and computes a stochastic neoclassical growth model where agents face uninsurable idiosyncratic labor income risk and heterogenous discount factors. Households value government purchases which are financed by income taxes. The government cannot commit to future streams of government purchases. We thus study the Markov perfect equilibria of such an economy. We also introduce a wealth bias into the political aggregation process. When exposed to standard aggregate productivity shocks, we show that such a model can explain three important features of government purchases in the data: government purchases are mildly procyclical, their dynamic correlation with one-year lagged output is higher than the corresponding contemporaneous correlation, and they are the most persistent component of aggregate demand. We also show that a representative agent model, models with insufficient wealth inequality and models with no wealth bias cannot explain these features of the data.