In Search of the Transmission Mechanism of Fiscal Policy

Most economists would agree that a hike in the federal funds rate will cause some slowdown in growth and inflation, and that the bulk of the empirical evidence is consistent with this statement. But perfectly reasonable economists can and do disagree even on the basic effects of a shock to government spending on goods and services: neoclassical models predict that in general, private consumption and the real wage will fall, while some neo-Keynesian models predict the opposite. This paper discusses alternative time series methodologies to identify government spending shocks and to estimate their effects. Applying these methodologies to data from the United States and three other OECD countries provides little evidence in favor of the neoclassical predictions. Using the US input-output tables, the paper then turns to industry-level evidence around two major military buildups to shed light on the effects of government spending shocks.