Finance and Economics Discussion Series

Revisiting the Supply-Side Effects of Government Spending

Vasia Panousi and George-Marios Angeletos
2009-01

Abstract: We revisit the macroeconomic effects of government consumption in the neoclassical growth model when agents face uninsured idiosyncratic investment risk. Under complete markets, a permanent increase in government consumption has no long-run effect on the interest rate and the capital-labor ratio, while it increases hours due to the negative wealth effect. These results are upset once we allow for incomplete markets. The same negative wealth effect now causes a reduction in risk taking and the demand for investment. This leads to a lower risk-free rate and, under certain conditions, also to a lower capital-labor ratio, and lower productivity.

Keywords: Fiscal policy, government spending, incomplete risk sharing, entrepreneurial risk