Government Spending Shocks, Consumption Dynamics, and Asset Prices

Abstract

Using an improved stock return-based measure that is uncorrelated with business cycle conditions, I examine the implications of government spending shocks on consumption dynamics and asset pricing. Estimates from vector autoregressions and local projections using monthly data show that government spending causes a short-term increase and a subsequent decrease in consumption. Non-linear models show that short-term increases in consumption occur only during recessions. In contrast, government spending causes substantial reductions in consumption during growth periods. Government spending shocks are associated with a risk premium in the time-series and cross-section of returns. Commonly used factor models fail to capture this premium.

Keywords: government spending shock, DMP returns, consumption growth, two-state model, factor model

JEL Classification: G12, E62, N42