The Effect of Government Spending on Private Consumption: A Puzzle?

The empirical finding that cyclical changes in government spending tend to be associated with positive responses of private consumption has been interpreted as a challenge for representative agent intertemporal optimizing theories, which usually imply that the negative wealth effect of higher fiscal spending reduces the households¿ consumption and leisure. The present paper shows that the evidence can be explained by a standard real business cycle type model. With a nonadditively separable utility function and a small intertemporal consumption elasticity, higher fiscal spending can raise consumption and lower investment, as in the data. The nonseparable utility model is shown to imply the same consumption Euler equation as a model with “rule-of-thumb” consumers who mechanically spend their income. [ABSTRACT FROM AUTHOR]