Ebook Identifying Government Spending Shocks: It’s All In The Timing
How does the economy respond to a rise in government purchases? Do consumption and real wages rise or fall? The literature remains divided on this issue. VAR techniques in which identification is achieved by assuming that government spending is predetermined within the quarter typically find that a positive government spending shock raises not only GDP and hours, but also consumption and the real wage (or labor productivity) (e.g. Rotemberg and Woodford 1992; Blanchard and Perotti 2002; Fatás and Mihov 2001; Mountford and Uhlig 2002; Perotti 2005; Pappa 2005; Caldara and Kamps 2006; and Galí, López-Salido, and Vallés 2007). In contrast, analyses using the Ramey-Shapiro (1998) “war dates” typically find that while government spending raises GDP and hours, it lowers consumption and the real wage (e.g. Ramey and Shapiro 1998; Edelberg, Eichenbaum, and Fisher 1999; Burnside, Eichenbaum, and Fisher 2004; and Cavallo 2005). Event studies such as Giavazzi and Pagano’s (1990) analysis of fiscal consolidations in several European countries, and Cullen and Fishback’s (2006) analysis of WWII spending on local retail sales generally show a negative effect of government spending on private consumption. Hall’s (1986) analysis using annual data back to 1920 finds a slightly negative effect of government purchases on consumption.
Whether government spending raises or lowers consumption and the real wage is crucial for our understanding of how government spending affects GDP and hours, as well as whether “stimulus packages” make sense. It is also important for distinguishing macroeconomic models. Consider first the neoclassical approach, as represented by papers such as Aiyagari, Christiano and Eichenbaum (1992) and Baxter and King (1993). A permanent increase in government spending financed by non distortionary means creates a negative wealth effect for the representative household. The household optimally responds by decreasing its consumption and increasing its labor supply. Output rises as a result. The increased labor supply lowers the real wage and raises the marginal product of capital in the short run. The rise in the marginal product of capital leads to more investment and capital accumulation, which eventually brings the real wage back to its starting value. In the new steady-state, consumption is lower and hours are higher. A temporary increase in government spending in the neoclassical model has less impact on output because of the smaller wealth effect. Depending on the persistence of the shock, investment can rise or fall. In the short run, hours should still rise and consumption should still fall.
The new Keynesian approach seeks to explain a rise in consumption, the real wage, and productivity found in most VAR analyses. For example Rotemberg and Woodford (1992) and Devereux, Head and Lapham (1996) propose models with oligopolistic (or monopolistic) competition and increasing returns in order to explain the rise in real wages and productivity. In the Devereux et al model, consumption may rise only if returns to specialization are sufficiently great. Galí, López-Salido, and Vallés (2006) show that only an “ultra-Keynesian” model with sticky prices, “rule-of-thumb” consumers, and off-the-labor-supply curve assumptions can explain how consumption and real wages can rise when government spending increases. Their paper makes clear how many special features the model must contain to explain the rise in consumption.
This paper reexamines the empirical evidence by comparing the two main empirical approaches to estimating the effects of government spending: the VAR approach and the Ramey Shapiro narrative approach. After reviewing the set-up of both approaches and the basic results, I show that a key difference appears to be in the timing. In particular, I show that both the Ramey-Shapiro dates and professional forecasts Granger-cause the VAR shocks. Thus, big increases in military spending are anticipated several quarters before they actually occur. I show this is also true for several notable cases of non-defense government spending changes. I then discuss how failing to account for the anticipation effect can explain some of the differences in the empirical results of the two approaches.
Although the Ramey-Shapiro military variable gets the timing right, it incorporates news in a very rudimentary way. Thus, in the final part of the paper, I construct two new measures of government spending shocks. The first builds on ideas by Romer and Romer (forthcoming) and uses narrative evidence to construct a new, richer variable of defense shocks. Romer and Romer use information from the legislative record to document tax policy changes. I instead must rely on news sources because government documents are not always released in a timely manner and because government officials have at times purposefully underestimated the cost of military actions. Using Business Week, as well as several newspaper sources, I construct an estimate of changes in the expected present value of government spending. My analysis extends back to the first quarter of 1939, so I am able to analyze the period of the greatest increase in government spending in U.S. history. For the most part, I find effects that are qualitatively similar to those of the simple Ramey-Shapiro military variable. When World War II is included, the multiplier is estimated to be around unity; when it is excluded it is estimated to be 0.6 to 0.8, depending on how it is calculated.
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