Does Consumption Change When Government Spending Changes?

Before starting, I would like to thank New Economist for the opportunity to guest blog here this week along with Edward Hugh, and I hope I can live up to this blog's excellent standards.  This first post is a bit lengthy - Mark Thoma

Given the size of the budget deficit in the U.S., understanding the consequences of deficits is a timely topic.  One area of uncertainty is how changes in government spending affect consumption.  Theoretically, there is a distinct difference regarding how a change in government spending, G, affects consumption, C, in real business cycle (RBC) models and in textbook IS/LM models.  In RBC models, an increase in G lowers the present discounted value of after tax income causing a negative wealth effect and a decline in consumption.  In the IS/LM model, an increase in G increases after tax income inducing an increase in consumption. 

The new NBER paper presented here shows that the New Keynesian (NK) model also has this feature with the appropriate modifications. Thus, the prediction depends upon the model used, RBC models predict an increase in G causes a decline in C and the NK (as modified in the paper) and IS/LM models predict the opposite.

What does the empirical evidence have to say on this question?  The paper discussed in this post reviews past empirical work and provides new empirical work of its own.  The paper comes to the conclusion that the evidence suggests that G and C are positively correlated, or at least not negatively correlated, contrary to the predictions of RBC models.

The NBER working paper by Jordi Galí, J. David López-Salido and Javier Vallés, Understanding the Effects of Government Spending on Consumption, does much more than just review and add to the empirical evidence on this issue, that is just what this post is highlighting. More generally, according to Ilian Mihov (PDF):

This is a very interesting and important paper. It makes two significant contributions to the literature on fiscal policy and monetary policy using dynamic stochastic general equilibrium models with sticky prices. The first contribution of the paper is the analysis of macroeconomic dynamics following a shock to government spending in a model that has rule-of-thumb consumers.

The second contribution – largely under-emphasized by the authors – is the documentation of how the effects of fiscal policy change with changes in the monetary policy rule. In my view the second contribution warrants significant attention by both policy-makers and modelers because it reveals the importance of accounting for the monetary policy rule in analyses of fiscal shocks...

However, as noted, it is the empirical work that is highlighted here.  Here’s a link to the paper, and passages from the introduction and the section on empirical evidence.  The paper makes reference to Ricardian equivalence which for some may be unfamiliar, so here's a link that may help.  And, if RBC models are unfamiliar, this link has a brief description:

Understanding the Effects of Government Spending on Consumption, NBER Working Paper 11578, August 2005, [Free Apr. 2004 version]:

Introduction:  What are the effects of changes in government purchases on aggregate economic activity? How are those effects transmitted? Even though such questions are central to macroeconomics … there is no widespread agreement on their answer. In particular, though most macroeconomic models predict that a rise in government purchases will have an expansionary effect on output, those models often differ regarding the implied effects on consumption.

…The standard RBC and the textbook IS-LM models provide a stark example of such differential qualitative predictions. ... The RBC model features infinitely-lived Ricardian households, whose consumption decisions at any point in time are based on an intertemporal budget constraint. Ceteris paribus, an increase in government spending lowers the present value of after-tax income, thus generating a negative wealth effect that induces a cut in consumption.

By way of contrast, in the IS-LM model consumers behave in a non-Ricardian fashion, with their consumption being a function of their current disposable income and not of their lifetime resources. Accordingly, the implied effect of an increase in government spending will depend critically on how the latter is financed, with the multiplier increasing with the extent of deficit financing. What does the existing empirical evidence have to say regarding the consumption effects of changes in government spending?...

An Overview of the Evidence:  …we start by summarizing the existing evidence on the response of consumption (and some other variables) to an exogenous increase in government spending, and provide some new evidence of our own. ...Unfortunately, the data does not seem to speak with a single voice on this issue: while some papers uncover a large, positive and significant response of consumption, others find that such a response is small and often insignificant. As far as we know, however, there is no evidence in the literature pointing to the large and significant negative consumption response that would be consistent with the predictions of the neoclassical model…

Here we provide some complementary evidence ... Our VAR includes a measure of government spending, GDP, hours worked, consumption of nondurables and services, private nonresidential investment, the real wage, the budget deficit, and personal disposable income. ... [In response to a government spending shock]… Total government spending rises significantly and persistently … Output rises persistently … as predicted by the theory. Most interestingly, however, consumption is also shown to rise on impact and to remain persistently above zero. A similar pattern is displayed by disposable income; in fact … the response of consumption tracks, almost one-for-one, that of disposable income.

With respect to the labor variables, our point estimates imply that both hours and the real wage rise persistently in response to the fiscal shock, although with some delay relative to government spending itself. By contrast investment falls slightly in the short run, though the response is not significant. Finally, the deficit rises significantly on impact, remaining positive for about two years.

They also discuss related empirical work:

Blanchard and Perotti (2002), Fatás and Mihov (2001), Perotti (2004), Mountford and Uhlig (2004), Ramey and Shapiro (1998), Edelberg, Eichenbaum and Fisher (1999), Burnside, Eichenbaum and Fisher (2003), Perotti (1999), and Alesina and Ardagna (1998).

They then conclude the empirical overview with:

Overall, we view the evidence discussed above as tending to favor the predictions of the traditional Keynesian model over those of the neoclassical model. In particular, none of the evidence appears to support the kind of strong negative comovement between output and consumption predicted by the neoclassical model in response to changes in government spending.

Furthermore, in trying to understand some of the empirical discrepancies discussed above it is worth emphasizing that the bulk of the papers focusing on the response to changes in government spending in "ordinary" times tend to support the traditional Keynesian hypothesis, in contrast with those that focus on "extraordinary" fiscal episodes (associated with wars or with large fiscal consolidations triggered by explosive debt dynamics).

Comments

[Edward Hugh]

"government spending in "ordinary" times"

Well this would be just my beef, both with the Keynesian and the RBC models, "ordinary times" smacks to me of a Weberian 'ideal type'. The problem is there may be no such thing. Every situation, like every unhappy family (Tolstoy) may be different in its own way on each and every occassion. I'm not saying there aren't trends (or even 'evolution') what I'm saying, I suppose, is that these classes of models don't seem to allow for them.

"those that focus on "extraordinary" fiscal episodes"

Like the post Maastricht SGP in the eurozone, where the strict limits and requirements to reduce the volume of debt as a proportion of GDP are to avoid precisely those explosive debt dynamics you mention. The question is, is demographic ageing an 'exceptional event' or does it form part of the natural order of things? Put this another way, should these changes be treated endogenously or exogenously in the models? If they were 'internalised' it would add a whole new level of realism to the debate about fiscal policy.

One last thing on Tolstoy: you know I don't think somehow that he believed in 'happy families'. Which means that all 'happy families' for T are the same for a very simple reason: they are inexistent. Which makes it kind of funny that this is one of the most widely used quotes in economic papers :).

[Asics Tiger]

I agree with you ,your saying is very good!

[Cheap Bikinis]

Good article.I will continue to focus on.