The Inflation Response to Government Spending Shocks: A Fiscal Price Puzzle?

Peter Lihn Jørgensen, Søren H. Ravn*

*Corresponding author for this work

Research output: Contribution to journalJournal articlepeer-review

4 Downloads (Pure)

Abstract

Standard New Keynesian models predict that expansionary fiscal policy is inflationary. In contrast, this paper presents empirical evidence that prices do not increase in response to a positive government spending shock. Instead, the response of prices is flat or even negative. This finding is robust across a wide range of specifications of our Structural Vector Autoregression (SVAR) model and across different price indices. The puzzling response of prices is accompanied by an increase in output and private consumption, as found in most of the existing literature, as well as an increase in Total Factor Productivity. We show that the introduction of variable technology utilization can enable an otherwise standard New Keynesian model to account for our empirical findings. The model implies that the government spending multiplier is substantially lower when the economy is in a fundamental liquidity trap, as compared to normal times, in contrast to the predictions of standard New Keynesian models.
Original languageEnglish
Article number103982
JournalEuropean Economic Review
Volume141
Number of pages43
ISSN0014-2921
DOIs
Publication statusPublished - Jan 2022

Bibliographical note

Published online: 1 December 2021.

Keywords

  • Government spending shocks
  • Fiscal policy
  • Business-cycle comovement
  • DSGE modeling
  • Endogenous productivity

Cite this