Government spending shocks and labor productivity

Abstract

A central question in the empirical fiscal policy literature is the magnitude, in fact even the sign, of the fiscal multiplier. Standard identification schemes for fiscal VAR models typically imply positive output as well as labor productivity responses to expansionary government spending shocks. The standard macro assumption of decreasing returns to labor, however, implies that expansionary government spending shocks should lead to increasing output and hours, but to decreasing labor productivity. To potentially reconcile theory and empirical analysis we impose, amongst other sign restrictions, opposite signs of the impulse responses of output and labor productivity to government spending shocks in eight- to ten-variable VAR models, estimated on quarterly US data. Doing so leads to contractionary effects of positive government spending shocks. This potentially surprising finding is robust to the inclusion of variable capital utilization rates and total factor productivity.