The Effect of Defense Spending on US Output: A Factor Augmented Vector Autoregression (FAVAR) Approach

Empirical evidence on the effect of defense spending on US output is at best mixed. Against this backdrop, this paper assesses the impact of a positive defense spending shock on the growth rate of real GNP using a FAVAR model estimated with 116 variables spanning the quarterly period of 1976:01 to 2005:02. Overall, the results show that a positive shock to the growth rate of the real defense spending translates to a positive and long lasting effect on the growth rate of real GNP, but the effect is significant only for two quarters. In addition, we indicate that the mixed empirical evidence could be a result of small information sets, by showing the sensitivity of the results to sample size using a small-scale VAR typically used in the literature to analyze the effect of defense spending on output. Finally, given that the FAVAR model was found outperform the VAR in forecasting the growth rate of real GNP, we concluded that the FAVAR framework is superior and should be relied upon more for the analysis of th