Non-Separable Preferences and Frisch Labor Supply: One Solution to a Fiscal Policy Puzzle

Abstract

This paper proposes a theoretical explanation of the empirical finding that private consumption increases in response to an increase in government spending. The explanation requires two ingredients. First, labor demand expands (e.g. prices are sticky). Second, general non-separable preferences over consumption and leisure should be such that Frisch labor supply elasticity is lower than the constant-consumption elasticity; this implies that constant-consumption labor supply shifts left. Existing empirical evidence on the relative magnitudes of the two elasticities supports this hypothesis. The parametric conditions under which the result occurs are consistent with restrictions of concavity and non-inferiority of consumption and leisure.

Keywords: fiscal policy, Frisch elasticity of labor supply, government spending, non-separable preferences, private consumption, sticky prices

JEL Classification: D11, E21, E62, H31