The Effect of Public Spending on Consumption: Reconciling Theory and Evidence

Recent empirical evidence from vector autoregressions (VARs) suggests that public spending shocks increase (crowd in) private consumption. Standard general equilibrium models predict the opposite. We show that a standard real business cycle (RBC) model in which public spending is chosen optimally can rationalize the crowding-in effect documented in the VAR literature. When such a model is used as a data-generating process, a VAR estimated using the artificial data yields a positive consumption response to an increase in public spending, consistent with the empirical findings. This result holds regardless of whether private and public purchases are complements or substitutes