Explaining the Effects of Government Spending Shocks on Consumption and the Real Exchange Rate

38 Pages Posted: 24 Aug 2007 Last revised: 22 Oct 2007

See all articles by Morten O. Ravn

Morten O. Ravn

European University Institute - Economics Department (ECO); London Business School - Department of Economics; University of Southampton; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Stephanie Schmitt-Grohé

Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Martín Uribe

Columbia University - Graduate School of Arts and Sciences - Department of Economics; National Bureau of Economic Research (NBER)

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Date Written: August 2007

Abstract

Using panel structural VAR analysis and quarterly data from four industrialized countries, we document that an increase in government purchases leads to an expansion in output and private consumption, a deterioration in the trade balance, and a depreciation of the real exchange rate (i.e., a decrease in the domestic CPI relative to the exchange-rate adjusted foreign CPI). We propose an explanation for these observed effects based on the deep habit mechanism. We estimate the key parameters of the deep-habit model employing a limited information approach. The predictions of the estimated deep-habit model fit well the observed responses of output, consumption, the trade balance, and the real exchange rate to an unanticipated government spending shock. In addition, the deep-habit model predicts that in response to an anticipated increase in government spending consumption and wages fail to increase on impact, which is consistent with the empirical evidence stemming from the narrative identification approach. In this way, the deep-habit model reconciles the findings of the SVAR and narrative literatures on the effects of government spending shocks.

Suggested Citation

Ravn, Morten O. and Schmitt-Grohe, Stephanie and Uribe, Martin, Explaining the Effects of Government Spending Shocks on Consumption and the Real Exchange Rate (August 2007). NBER Working Paper No. w13328, Available at SSRN: https://ssrn.com/abstract=1008822

Morten O. Ravn (Contact Author)

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Stephanie Schmitt-Grohe

Centre for Economic Policy Research (CEPR) ( email )

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Martin Uribe

Columbia University - Graduate School of Arts and Sciences - Department of Economics ( email )

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