Government Spending Shocks and Asset Prices

Abstract

The effects of government spending on consumption growth and the cross-sectional pricing of stocks depend on the state of the economy when the shock occurs. During times of high economic growth, government spending shocks lead to a drop in future consumption. To compensate for consumption disruptions, fluctuation averse investors command a risk premium for government spending shocks during high growth periods. In contrast, during low growth periods, government spending shocks have no impact on consumption and asset prices. I show that the results are unlikely to be influenced by omitted variables or erroneous classification of economic states.

Keywords: government spending shock, DMC returns, two-state model, factor model

JEL Classification: G12, E62, N42