Defense Government Spending Is Contractionary, Civilian Government Spending Is Expansionary
Impulse responses to government spending shocks in Standard Vector Autoregressions (SVARs) typically display "expansionary" features. However, SVARs can be subject to a "non-fundamentalness" problem. "Expectations - Augmented" VARs (EVARs), which use direct measures of forecasts of defense spending, typically display "contractionary" responses to a defense news shock. I show that, when properly specified, SVARs and EVARs give virtually identical results. The reason for the widespread, opposite view is that defense shocks have "contractionary" effects while civilian government spending shocks have "expansionary" effects. Existing EVARs and SVARs, however, include only total government spending. In addition, the former are typically estimated on samples that include WWII and the Korean war, when defense shocks prevailed, while the latter are estimated mostly on post-1953 samples, when civilian shocks prevailed.
This is a vastly revised version of a paper previously circulated under the title: "Expectations and Fiscal Policy: an Empirical Investigation". I thank Jacopo Perego for excellent research assistance, and Alberto Alesina, Fabio Canova, Carlo Favero, Luca Gambetti, Marco Lippi, Giorgio Primiceri, Morten Ravn, Barbara Rossi, Luca Sala, and seminar participants at Universitat Pompeu Fabra for very useful comments and discussions. This paper was produced as part of the project Growth and Sustainability Policies for Europe (GRASP), a collaborative project funded by the European Commission's Seventh Research Framework Programme, contract number 244725. The views expressed herein are those of the author and do not necessarily reflect the views of the National Bureau of Economic Research.