The Output and Welfare Effects of Government Spending Shocks over the Business Cycle∗

This paper studies the state-dependence of the output and welfare effects of shocks to government purchases in a canonical medium scale DSGE model. When monetary policy is characterized by a Taylor rule, the output multiplier (the change in output for a one unit change in government spending) is countercyclical but close to constant across states of the business cycle, whereas the welfare multiplier (the consumption equivalent change in a measure of aggregate welfare for the same change in government spending) is quite volatile and procyclical. These results are robust to different means of fiscal finance. When the nominal interest rate is unresponsive to economic conditions, such as would be the case at the zero lower bound, both the output and welfare multipliers are larger and significantly more volatile across states of the business cycle than under a Taylor rule, and the welfare multiplier may be countercyclical. In the context of the canonical DSGE model which we study, our analysis suggests that countercyclical government spending is undesirable as a general policy prescription but also highlights situations in which it might be beneficial. ∗We are grateful to Rudi Bachmann, Bob Flood, Tim Fuerst, Robert Lester, Michael Pries, Jeff Thurk, and seminar participants at Notre Dame, the University of Texas at Austin, the University of Mannheim, Purdue University, Miami University, Eastern Michigan University, Dickinson College, Montclair State University, the University of Mississippi, the Fall 2013 Midwest Macro Meetings, and the 2015 Econometric Society World Congress for several comments which have substantially improved the paper.