War and peace: investigations into the macroeconomic effects of fiscal policy

Popescu, Adina (2008) War and peace: investigations into the macroeconomic effects of fiscal policy. Doctoral thesis, University of London: London Business School.

Abstract

In spite of extensive research on the effects of fiscal policy on the macroeconomy, the response of private consumption to government spending shocks remains controversial both from an empirical and theoretical perspective. In this dissertation we argue that our understanding of this relationship can be enhanced by considering the disaggregation of government spending into an exogenous component, assimilated to military expenditures, and a utility-yielding part, which is comprised of civilian government expenditures such as education, healthcare, etc. We explore empirically whether these two types of spending have different effects on private sector variables. We then move on to offer a theoretical justfication for the observed dichotomy in a simple neoclassical optimal fiscal policy model. Finally, we discuss a methodology for checking the robustness of our results versus alternative explanations, thus offering a strategy for validating the link between the model and the empirical results. In the first paper we reconsider the evidence on the effects of government spending shocks on private consumption by distinguishing between military and non-military shocks which are identified using sign restrictions motivated by both the theoretical and empirical literature. The main findings are that civilian government spending has positive multipliers on private consumption, while the defense government spending has negative multipliers. In the second paper we study whether a suitably altered dynamic general equilibrium model in which the agents' preferences include the government provided goods can explain the response of private consumption to government spending shocks, without resorting to assumptions about sticky prices or wages. We show that in this model the utility-yielding component of government expenditure crowds in private consumption while the exogenous part crowds it out, generating values for the scale multipliers which are consistent with the US post-war evidence. In the final paper, we show that it is possible to distinguish between two different explanations for the response of private consumption to government spending shocks (the in-the-utility public good model of proposed in this dissertation and the DNKY model with rule-of-thumb consumers in Galí et al. (2005)) using the type of sign restrictions identification procedure put forward in the first paper.