Academic journal article Federal Reserve Bank of St. Louis Review

A Primer on the Empirical Identification of Government Spending Shocks

Academic journal article Federal Reserve Bank of St. Louis Review

A Primer on the Empirical Identification of Government Spending Shocks

Article excerpt

The empirical literature on the effects of government spending shocks lacks unanimity about the responses of consumption and wages. Proponents of shocks identified by structural vector auto-regressions (VARs) find results consistent with New Keynesian models: consumption and wages increase. On the other hand, proponents of the narrative approach find results consistent with neoclassical models: consumption and wages decrease. This paper reviews these two identifications and confirms their differences by using standard economic series. It also uses alternative measures of government spending, output, and the labor market and shows that, although there are minor fluctuations within each identification, the disparate results between the two are robust to the alternative measures. However, under the structural VAR approach, the authors find some differences between the responses to federal and state/local government spending. (JEL C32, E62)

Federal Reserve Bank of St. Louis Review, March/April 2008, 90(2), pp. 117-132.


Many textbook macroeconomic models contain predictions about the effects of fiscal policy. Unfortunately, these models lack unanimity about the response of some variables to surprise increases in government spending. For example, neoclassical models and New Keynesian models have opposing predictions regarding the direction of the effect of government spending shocks on consumption and real wages. Neoclassical models predict that, when a government spending shock hits the economy, households, facing the prospect of higher taxes, experience a negative wealth effect. Households respond by lowering their consumption and leisure. The increased labor supply from households also leads to a fall in real wages for any given labor demand. New Keynesian models instead predict that consumption and real wages rise in response to a positive government spending shock. These models often contain features that generate countercyclical markups (e.g., nominal price rigidities or deep habits [see Ravn, Schmitt-Grohe, and Uribe (2006)]), which in turn cause labor demand to shift up in response to a government spending shock. This results in rising wages and higher consumption for the households due to substitution effects or the presence of credit constraints.

The empirical literature has been unable to resolve this controversy. Depending on the nature of the identifying assumptions, the empirical literature finds disparate stylized facts regarding the responses of some variables to government spending shocks. The responses of consumption and wages, in particular, can take on different signs depending on the assumptions used to identify fiscal policy shocks. The structural vector autoregression (VAR) approach that Blanchard and Perotti (2002) and Fatas and Mihov (2001) use to identify government spending shocks yields a positive response for output, consumption, and real wages. On the other hand, the narrative approach introduced by Ramey and Shapiro (1998) uses military spending events as a proxy for exogenous shocks to government spending. This approach typically finds that, in response to these large military buildups, output rises but consumption and real wages fall. (1)

A few recent papers (e.g., Ramey, 2006, and Perotti, 2007) have reenergized this debate regarding the responses of economic variables under different identification schemes. One concern is that the structural VAR approach may not be identifying exogenous innovations to fiscal policy. That is, the timing restrictions used in structural VARs may identify shocks that are anticipated by economic agents. This would confound the econometrician's ability to disentangle the effects of fiscal policy. This results in responses that are biased by some omitted predictors. (2) Criticism can also be levied on the narrative approach. This methodology treats all of the large fiscal episodes equally rather than allowing for some variation in the size and shape of the response. …

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