Gali Valles Salido 2007

UNDERSTANDING THE EFFECTS
OF GOVERNMENT SPENDING
ON CONSUMPTION
Jordi Galí Javier Vallés

CREI and Universitat Pompeu Fabra Economic Bureau of Spanish
Prime Minister
J. David López-Salido
Federal Reserve Board
Abstract
Recent evidence suggests that consumption rises in response to an increase in government
spending. That finding cannot be easily reconciled with existing optimizing business cycle
models. We extend the standard new Keynesian model to allow for the presence of rule-of-thumb
consumers. We show how the interaction of the latter with sticky prices and deficit financing
can account for the existing evidence on the effects of government spending. (JEL: E32, E62)
1. Introduction
What are the effects of changes in government purchases on aggregate economic

activity? How are those effects transmitted? Even though such questions are
central to macroeconomics and its ability to inform economic policy, there is no
widespread agreement on their answer. In particular, though most macroeconomic
models predict that a rise in government purchases will have an expansion-
ary effect on output, those models often differ regarding the implied effects on
consumption. Because the latter variable is the largest component of aggregate
Acknowledgments: We wish to thank Alberto Alesina, Javier Andrés, Florin Bilbiie, Günter
Coenen, Gabriel Fagan, Eric Leeper, Ilian Mihov, Valery Ramey, Michael Reiter, Jaume Ventura,
Lutz Weinke, co-editor Roberto Perotti, two anonymous referees, and seminar participants at the
Bank of Spain, Bank of England, CREI-UPF, IGIER-Bocconi, INSEAD, York, Salamanca, NBER
Summer Institute 2002, the 1st Workshop on Dynamic Macroeconomics at Hydra, the EEA Meetings
in Stockholm, and the 2nd International Research Forum on Monetary Policy for useful comments
and suggestions. Galí acknowledges the financial support and hospitality of the Banco de España,
and CREA-Barcelona Economics and MCyT (grant SEJ 2005-01124) for research support. Anton
Nakov provided excellent research assistance. This paper was written while the last two authors
worked at the Research Department of the Banco de España. The opinions and analyses are the
responsibility of the authors and, therefore, do not necessarily coincide with those of the Banco de
España, the Eurosystem, the Board of Governors of the Federal Reserve System, or any other person
associated with the Federal Reserve System.
E-mail addresses: Galí: [email protected]; López-Salido: [email protected]; and Vallés:
[email protected]
Journal of the European Economic Association March 2007 5(1):227–270

© 2007 by the European Economic Association
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228 Journal of the European Economic Association
demand, its response is a key determinant of the size of the government spending
multiplier.
The standard RBC and the textbook IS-LM models provide a stark example
of such differential qualitative predictions. The standard RBC model generally
predicts a decline in consumption in response to a rise in government purchases
of goods and services (henceforth, government spending, for short). In contrast,
the IS-LM model predicts that consumption should rise, hence amplifying the
effects of the expansion in government spending on output. Of course, the rea-
son for the differential impact across those two models lies in how consumers
are assumed to behave in each case. The RBC model features infinitely-lived
Ricardian households, whose consumption decisions at any point in time are
based on an intertemporal budget constraint. Ceteris paribus, an increase in gov-
ernment spending lowers the present value of after-tax income, thus generating
a negative wealth effect that induces a cut in consumption.1 By way of contrast,
in the IS-LM model consumers behave in a non-Ricardian fashion, with their
consumption being a function of their current disposable income and not of their
lifetime resources. Accordingly, the implied effect of an increase in government
spending will depend critically on how the latter is financed, with the multiplier
increasing with the extent of deficit financing.2
What does the existing empirical evidence have to say regarding the con-
sumption effects of changes in government spending? Can it help discriminate
between the two paradigms, on the grounds of the observed response of consump-
tion? A number of recent empirical papers shed some light on those questions.
They all apply multivariate time series methods in order to estimate the responses
of consumption and a number of other variables to an exogenous increase in
government spending. They differ, however, on the assumptions made in order
to identify the exogenous component of that variable. In Section 2 we describe
in some detail the findings from that literature that are most relevant to our pur-
poses, and provide some additional empirical results of our own. In particular,
1. The mechanisms underlying those effects are described in detail in Aiyagari, Christiano, and
Eichenbaum (1990), Baxter and King (1993), Christiano and Eichenbaum (1992), and Fatás and
Mihov (2001), among others. In a nutshell, an increase in (non-productive) government purchases,
financed by current or future lump-sum taxes, has a negative wealth effect which is reflected in lower
consumption. It also induces a rise in the quantity of labor supplied at any given wage. The latter
effect leads, in equilibrium, to a lower real wage, higher employment and higher output. The increase
in employment leads, if sufficiently persistent, to a rise in the expected return to capital, and may
trigger a rise in investment. In the latter case the size of the multiplier is greater or less than one,
depending on parameter values.
2. See, for example, Blanchard (2003). The total effect on output will also depend on the investment
response. Under the assumption of a constant money supply, generally maintained in textbook
versions of that model, the rise in consumption is accompanied by an investment decline (resulting
from a higher interest rate). If instead the central bank holds the interest rate steady in the face of the
increase in government spending, the implied effect on investment is nil. However, any “intermediate”
response of the central bank (i.e., one that does not imply full accommodation of the higher money
demand induced by the rise in output) will also induce a fall in investment in the IS-LM model.
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Galí et al. Effects of Government Spending on Consumption 229
and like several other authors that preceded us, we find that a positive government
spending shock leads to a significant increase in consumption, while investment
either falls or does not respond significantly. Thus, our evidence seems to be con-
sistent with the predictions of models with non-Ricardian consumers and hard to
reconcile with those of the neoclassical paradigm.
After reviewing the evidence, we turn to our paper’s main contribution: The
development of a simple dynamic general equilibrium model that can potentially
account for that evidence. Our framework shares many ingredients with recent
dynamic optimizing sticky price models, though we modify the latter by allow-
ing for the presence of rule-of-thumb behavior by some households.3 Following
Campbell and Mankiw (1989), we assume that rule-of-thumb consumers do not
borrow or save; instead, they are assumed to consume their current income fully.
In our model, rule-of-thumb consumers coexist with conventional infinite-horizon
Ricardian consumers.
The introduction of rule-of-thumb consumers in our model is motivated by an
extensive empirical literature pointing to substantial deviations from the perma-
nent income hypothesis. Much of that literature provides evidence of “excessive”
dependence of consumption on current income. That evidence is based on the
analysis of aggregate time series,4 as well as natural experiments using micro
data (e.g., response to anticipated tax refunds).5 That evidence also seems consis-
tent with the observation that a significant fraction of households have near-zero
net worth.6 On the basis of that evidence, Mankiw (2000) calls for the systematic
incorporation of non-Ricardian households in macroeconomic models, and for
an examination of the policy implications of their presence.
As further explained below, the existence of non-Ricardian households cannot
in itself generate a positive response of consumption to a rise in government
spending. To see this, consider the following equilibrium condition
mpnt = µt + ct + ϕnt ,
where mpnt , ct , and nt represent the (logs) of the marginal product of labor, con-
sumption, and hours worked, respectively. The term ct + ϕnt represents the (log)
marginal rate of substitution, with parameter ϕ > 0 measuring the curvature of the
marginal disutility of labor. Variable µt is thus the wedge between the marginal
rate of substitution and the marginal product of labor, and can be interpreted as
the sum of both the (log) wage and price markups, as discussed in Galí, Gertler,
and López-Salido (2007).
3. See, for example, Rotemberg and Woodford (1999), Clarida, Galí, and Gertler (1999), or
Woodford (2003) for a description of the standard new Keynesian model.
4. See, for example, Campbell and Mankiw (1989) and Deaton (1992) and references therein.
5. See, for example, Souleles (1999) and Johnson, Parker, and Souleles (2004).
6. See, for example, Wolff (1998).
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Consider first an economy with a constant wedge, µt = µ for all t. Notice

that the particular case of µ = 0 corresponds to the perfectly competitive case
often assumed in the RBC literature. According to both theory and evidence, an
increase in government purchases raises hours and, under standard assumptions,
lowers the marginal product of labor. Thus, it follows that consumption must
drop if the previous condition is to be satisfied. Hence, a necessary condition for
consumption to rise in response to a fiscal expansion is the existence of a simulta-
neous decline in the wedge µt . This motivates the introduction in our framework
of the assumption of sticky prices in goods markets and, at least in one version
of our model, of imperfectly competitive labor markets. Those complementary
assumptions interact with the presence of non-Ricardian consumers in a way that
makes it possible to reverse the sign of the response of consumption to changes in
government spending. As described subsequently, our model predicts responses
of aggregate consumption and other variables that are in line with the existing
evidence, given plausible calibrations of the fraction of rule-of-thumb consumers,
the degree of price stickiness, and the extent of deficit financing.
Beyond the narrower focus of the present paper, a simple lesson emerges
from our analysis: Allowing for deviations from the strict Ricardian behavior
assumed in the majority of existing macro models may be required in order to
capture important aspects of the economy’s workings.7 Our proposed framework,
based on the simple model of rule-of-thumb consumers of Campbell and Mankiw
(1989), although admittedly ad-hoc, provides in our view a good starting point.
The rest of the paper is organized as follows. Section 2 describes the existing
empirical literature and provides some new evidence. Section 3 lays out the model
and its different blocks. Section 4 contains an analysis of the model’s equilibrium
dynamics. Section 5 examines the equilibrium response to a government spending
shock under alternative calibrations, focusing on the response of consumption and
its consistency with the existing evidence. Section 6 summarizes the main findings
of the paper and points to potential extensions and directions for further research.
2. An Overview of the Evidence
In the present section we start by summarizing the existing evidence on the

response of consumption (and some other variables) to an exogenous increase
in government spending, and providing some new evidence of our own. Most
of the existing evidence relies on structural vector autoregressive models, with
different papers using alternative identification schemes. Unfortunately, the data
does not seem to speak with a single voice on this issue: Although some papers
7. In a companion paper (Galí, López-Salido, and Vallés 2004), we study the implications of
rule-of-thumb consumers for the stability properties of Taylor-type rules.
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uncover a large, positive, and significant response of consumption, others find

that such a response is small and often insignificant. As far as we know, however,
there is no evidence in the literature pointing to the large and significant nega-
tive consumption response that would be consistent with the predictions of the
neoclassical model.
Blanchard and Perotti (2002) and Fatás and Mihov (2001) identify exogenous
shocks to government spending by assuming that the latter variable is predeter-
mined relative to the other variables included in the VAR. Their most relevant
findings for our purposes can be summarized as follows. First, a positive shock
to government spending leads to a persistent rise in that variable. Second, the
implied fiscal expansion generates a positive response in output, with the asso-
ciated multiplier being greater than one in Fatás and Mihov, but close to one in
Blanchard and Perotti. Third, in both papers the fiscal expansion leads to large
(and significant) increases in consumption. Fourth, the response of investment to
the spending shock is found to be insignificant in Fatás and Mihov, but negative
(and significant) in Blanchard and Perotti.
Here we provide some complementary evidence using an identification strat-
egy similar to the above mentioned papers. Using U.S. quarterly data, we estimate
the responses of several macroeconomic variables to a government spending
shock. The latter is identified by assuming that government purchases are not
affected contemporaneously (i.e., within the quarter) by the innovations in the
other variables contained in a vector autoregression (VAR).8 Our VAR includes
a measure of government spending, GDP, hours worked, consumption of non-
durables and services, private nonresidential investment, the real wage, the budget
deficit, and personal disposable income. In a way consistent with the model devel-
oped herein, both government spending and the budget deficit enter the VAR as
a ratio to trend GDP, where the latter is proxied by (lagged) potential output. The
remaining variables are specified in logs, following convention.9
8. Qualitatively, the results herein are robust to the use of military spending (instead of total
government purchases) as a predetermined variable in the VAR, as in Rotemberg and Woodford
(1992).
9. We use quarterly U.S. data over the period 1954:I–2003:IV. The series were drawn from
Estima’s USECON database (acronyms reported in brackets below). These include government
(Federal + State + Local) consumption and gross investment expenditures (GH), gross domestic
product (GDPH), a measure of aggregate hours obtained by multiplying total civilian employment
(LE) by weekly average hours in manufacturing (LRMANUA), nonfarm business hours (LXNFH),
the real compensation per hour in the nonfarm business sector (LXNFR), consumption of nondurable
and services (CNH + CSH), non-residential investment (FNH), and the CBO estimate of potential
GDP (GDPPOTHQ). All quantity variables are in log levels, and normalized by the size of the civil-
ian population over 16 years old (LNN). We included four lags of each variable in the VAR. Our
deficit measure corresponds to gross government investment (GFDI + GFNI + GSI) minus gross
government savings (obtained from the FRED-II database). The resulting variable, expressed in
nominal terms, was normalized by the lagged trend nominal GDP (GDPPOTQ). Finally, disposable
income corresponds to real personal disposable income, also drawn from the FRED-II.
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Figure 1. The dynamic effects of a government spending shock.

Note: Estimated impulse responses to a government spending shock in the large VAR. Sample Period 1954:I–2003:IV.
The horizontal axis represents quarters after the shock. Confidence intervals correspond ±1 standard deviations of empir-
ical distributions, based on 1,000 Monte Carlo replications. The right bottom panel plots the point estimates of both
consumption (solid line) and disposable income (dashed line).
Figure 1 displays the estimated impulse responses. Total government spend-

ing rises significantly and persistently, with a half-life of about four years. Output
rises persistently in response to that shock, as predicted by the theory. Most inter-
estingly, however, consumption is also shown to rise on impact and to remain
persistently above zero. A similar pattern is displayed by disposable income;
in fact, as shown in the bottom right graph, the response of consumption tracks,
almost one-for-one, that of disposable income. With respect to the labor variables,
our point estimates imply that both hours and the real wage rise persistently in
response to the fiscal shock, although with some delay relative to government
spending itself.10 By contrast, investment falls slightly in the short run, though
the response is not significant. Finally, the deficit rises significantly on impact,
remaining positive for about two years.
Our point estimates in Figure 1 imply a government spending multiplier on
output, dYt+k /dGt , of 0.78 on impact (k = 0), and of 1.74 at the end of the second
year (k = 8). Such estimated multipliers are of a magnitude similar to the ones
reported by Blanchard and Perotti (2002). They are also roughly consistent with
the range of estimated short-run expenditure multipliers generated by a variety of
10. Fatás and Mihov (2001) also uncover a significant rise in the real wage in response to a spending
shock, using compensation per hour in the non-farm business sector as a measure of the real wage.
The positive comovement between hours and the real wage in response to a shock in military spending
was originally emphasized by Rotemberg and Woodford (1992). See also Rotemberg and Woodford
(1995).
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Table 1. Estimated effects of government spending shocks.

Estimated Fiscal Multipliers Implied
Output Consumption Fiscal Parameters
1stQ 4thQ 8thQ 1stQ 4thQ 8thQ ρg φg φb
1948:I–2003:IV
Baseline spending
Small VAR 0.51 0.31 0.28 0.04 0.09 0.19 0.85 0.10 0.10
Larger VAR 0.41 0.31 0.68 0.07 0.11 0.49 0.80 0.06 0.06
Excluding military
Small VAR 0.15 -0.12 0.34 -0.11 0.24 0.32 0.95 0.005 0.60
Larger VAR 0.36 0.62 1.53 0.03 0.51 0.68 0.94 0.005 0.60
1954:I–2003:IV
Baseline spending
Small VAR 0.74 0.75 1.22 0.14 0.46 0.73 0.95 0.13 0.20
Larger VAR 0.68 0.70 1.74 0.17 0.29 0.95 0.95 0.10 0.30
Excluding military
Small VAR 0.63 1.95 2.60 0.25 1.41 1.12 0.95 0.05 0.50
Larger VAR 0.74 2.37 3.50 0.37 1.39 1.76 0.95 0.01 0.50
1960:I–2003:IV
Baseline spending
Small VAR 0.91 1.05 1.32 0.19 0.59 0.84 0.95 0.13 0.20
Larger VAR 0.81 0.44 0.76 0.20 0.25 0.45 0.95 0.08 0.20
Excluding military
Small VAR 0.72 1.14 1.19 0.17 0.78 0.68 0.94 0.03 0.50
Larger VAR 1.13 1.89 2.08 0.40 1.14 1.07 0.98 0.01 0.55
Note: Large VAR corresponds to the 8-variable VAR described in the text; Small VAR estimates are based on a 4-variable
VAR including government spending, output, consumption, and the deficit. Government spending excluding military was
obtained as GFNEH + GSEH + GFNIH + GSIH. For each specification ρg is the AR(1) coefficient that matches the
half-life of the estimated government spending response. Parameter φg is obtained as the difference of the VAR-estimated
impact effects of government spending and deficit, respectively. Finally, given ρg and φg , we calibrate the parameter φb
such that the dynamics of government spending (21) and debt (37) are consistent with the horizon at which the deficit is
back to steady state, matching our empirical VAR responses of the fiscal deficit.
macroeconometric models.11 Most important for our purposes is the observation

that the multiplier on consumption is always positive, going from 0.17 on impact
to 0.95 at the end of the second year.
Table 1 illustrates the robustness of these findings to alternative specifications
of the VAR, including number of variables (4 vs. 8 variables), sample period
(full postwar, post–Korean war, and post-1960), and definition of government
spending (excluding and including military spending).12 The left panel of the table
reports the size of the multipliers on output and consumption at different horizons
(on impact, one-year, and two-year horizons, respectively).13 Although the exact
11. See Hemming, Kell, and Mahfouz (2002) and the survey of the evidence provided in IMF
(2004, Chap. 2).
12. See Table 1 for details.
13. The right panel is used herein for the purposes of model calibration.
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size of the estimated multipliers varies somewhat across specifications, the central
finding of a positive response of consumption holds for the vast majority of
cases.14
As previously mentioned, some papers in the literature call into question (or
at least qualify) the previous evidence. Perotti (2004) applies the methodology
of Blanchard and Perotti (2002) to several OECD countries. He emphasizes the
evidence of subsample instability in the effects of government spending shocks,
with the responses in the 1980s and 1990s being more muted than in the earlier
period. Nevertheless, the sign and magnitude of the response of private con-
sumption in Perotti’s estimates largely mimics that of GDP, both across countries
and across sample periods. Hence, his findings support a positive comovement
between consumption and income, conditional on government spending shocks,
in a way consistent with the model developed herein (though at odds with the
neoclassical model).15
Mountford and Uhlig (2004) apply the agnostic identification procedure orig-
inally proposed in Uhlig (2005) to identify and estimate the effects of a “balanced
budget” and a “deficit spending” shock.16 They find that government spending
shocks crowd out both residential and non-residential investment, but they hardly
change consumption (the response of the latter is small and insignificant).
Ramey and Shapiro (1998) use a narrative approach to identify shocks that
raise military spending, and which they codify by means of a dummy variable
(widely known as the “Ramey-Shapiro dummy”). They find that nondurable con-
sumption displays a slight, though hardly significant decline, whereas durables
consumption falls persistently, but only after a brief but quantitatively large rise
on impact. They also find that the product wage decreases, even though the real
wage remains pretty much unchanged.17
Several other papers have used subsequently the identification scheme pro-
posed by Ramey and Shapiro in order to study the effects of exogenous changes
in government spending on different variables. Thus, Edelberg, Eichenbaum, and
Fisher (1999) show that a Ramey-Shapiro episode triggers a fall in real wages,
an increase in non-residential investment, and a mild and delayed fall in the con-
sumption of nondurables and services, though durables consumption increases
on impact. More recent work by Burnside, Eichenbaum, and Fisher (2003) using
14. The only exception corresponds to the small VAR specification over the full sample period
and excluding military spending. Yet the underlying impulse responses (not shown) indicate that the
slightly negative impact effect on consumption is quickly reversed in that case.
15. The response of private investment to the same shock tends to be negative, especially in the
second sample period.
16. This method is based on sign and near-zero restrictions on impulse responses.
17. Ramey and Shapiro (1998) provide a potential explanation of the comovements of consumption
and real wages in response to a change in military spending, based on a two-sector model with costly
capital reallocation across sectors, and in which military expenditures are concentrated in one of the
two sectors (manufacturing).
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a similar approach reports a flat response of aggregate consumption in the short

run, followed by a small (and insignificant) rise in that variable several quarters
after the Ramey-Shapiro episode is triggered.
Another branch of the literature, exemplified by the work of Giavazzi and
Pagano (1990), has uncovered the presence of “non-Keynesian effects” (i.e., neg-
ative spending multipliers) during large fiscal consolidations, with output rising
significantly despite large cuts in government spending. In particular, Perotti
(1999) finds evidence of a negative comovement of consumption and govern-
ment spending during such episodes of fiscal consolidation (and hence large
spending cuts), but only in circumstances of “fiscal stress” (defined by unusually
high debt/GDP ratios). In “normal” times, however, the estimated effects have the
opposite sign, that is, they imply a positive response of consumption to a rise in
government purchases. Nevertheless, as shown in Alesina and Ardagna (1998),
the evidence of non-Keynesian effects during fiscal consolidations can hardly
be interpreted as favorable to the neoclassical model because, on average, cuts in
government spending raise both output and consumption during those episodes.18
Overall, we view the evidence discussed as tending to favor the predictions of
the traditional Keynesian model over those of the neoclassical model. In particular,
none of the evidence appears to support the kind of strong negative comovement
between output and consumption predicted by the neoclassical model in response
to changes in government spending. Furthermore, in trying to understand some
of the empirical discrepancies discussed above it is worth emphasizing that the
bulk of the papers focusing on the response to changes in government spending in
“ordinary” times tend to support the traditional Keynesian hypothesis, in contrast
with those that focus on “extraordinary” fiscal episodes (associated with wars or
with large fiscal consolidations triggered by explosive debt dynamics).
In light of those considerations, we view the model developed herein as an
attempt to account for the effects of government spending shocks in “normal”
times, as opposed to extraordinary episodes. Accordingly, we explore the condi-
tions under which a dynamic general equilibrium model with nominal rigidities
and rule-of-thumb consumers can account for the positive comovement of con-
sumption and government purchases that arises in response to small exogenous
variations in the latter variable.
3. A New Keynesian Model with Rule-of-Thumb Consumers
The economy consists of two types of households, a continuum of firms producing

differentiated intermediate goods, a perfectly competitive firm producing a final
good, a central bank in charge of monetary policy, and a fiscal authority. Next
18. See Table 6 in Alesina and Ardagna (1998).
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we describe the objectives and constraints of the different agents. Except for
the presence of rule-of-thumb consumers, our framework consists of a standard
dynamic stochastic general equilibrium model with staggered price setting à la
Calvo.19
3.1. Households
We assume a continuum of infinitely lived households, indexed by i ∈ [0, 1].

A fraction 1 − λ of households have access to capital markets where they can
trade a full set of contingent securities, and buy and sell physical capital (which
they accumulate and rent out to firms). We use the term optimizing or Ricardian
to refer to that subset of households. The remaining fraction λ of households
do not own any assets nor have any liabilities, and just consume their current
labor income. We refer to them as rule-of-thumb households. Different inter-
pretations for that behavior include myopia, lack of access to capital markets,
fear of saving, ignorance of intertemporal trading opportunities, and so forth. Our
assumptions imply an admittedly extreme form of non-Ricardian behavior among
rule-of-thumb households, but one that captures in a simple and parsimonious way
some of the existing evidence, without invoking a specific explanation. Campbell
and Mankiw (1989) provide some aggregate evidence, based on estimates of a
modified Euler equation, of the quantitative importance of such rule-of-thumb
consumers in the U.S. and other industrialized economies.20
Optimizing households. Let Cto , and Lot represent consumption and leisure for
optimizing households. Preferences are defined by the discount factor β ∈ (0, 1)
and the period utility U (Cto , Lot ). A typical household of this type seeks to
maximize
∞

E0 β t U (Cto , Nto ), (1)
t=0
subject to the sequence of budget constraints
Pt (Cto + Ito ) + Rt−1 Bt+1

o
= Wt Pt Nto + Rtk Pt Kto + Bto + Dto − Pt Tto (2)
19. Most of the recent monetary models with nominal rigidities abstract from capital accumulation.
A list of exceptions includes King and Watson (1996), Yun (1996), Dotsey (1999), Kim (2000) and
Dupor (2002). In our framework, the existence of a mechanism to smooth consumption over time
is important in order for the distinction between Ricardian and non-Ricardian consumers to be
meaningful, thus justifying the need for introducing capital accumulation explicitly.
20. Mankiw (2000) reviews more recent microeconomic evidence consistent with that view.
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and the capital accumulation equation

Ito
o
Kt+1 = (1 − δ)Kto + φ Kto . (3)
Kto
At the beginning of the period the consumer receives labor income Wt Pt Nto ,
where Wt is the real wage, Pt is the price level, and Nto denotes hours of work.
He also receives income from renting his capital holdings Kto to firms at the (real)
rental cost Rtk . Bto is the quantity of nominally riskless one-period bonds carried
over from period t −1, and paying one unit of the numéraire in period t. Rt denotes
the gross nominal return on bonds purchased in period t. Dto are dividends from
ownership of firms, Tto denotes lump-sum taxes (or transfers, if negative) paid by
these consumers. Cto and Ito denote, respectively, consumption and investment
expenditures, in real terms. Pt is the price of the final good. Capital adjustment
costs are introduced through the term φ(Ito /Kto )Kto , which determines the change
in the capital stock induced by investment spending Ito . We assume φ > 0, and
φ ≤ 0, with φ (δ) = 1, and φ(δ) = δ.
In what follows we specialize the period utility—common to all
households—to take the form
N 1+ϕ
U (C, L) ≡ log C − ,
1+ϕ
where ϕ ≥ 0.
The first order conditions for the optimizing consumer’s problem can be
written as

Pt
1 = Rt Et t,t+1 , (4)
Pt+1

o
It+1
Qt = Et t,t+1 k
Rt+1 + Qt+1 (1 − δ) + φt+1 − o φt+1 , (5)
Kt+1
1
Qt = , (6)
Ito
φ Kto
where t,t+k is the stochastic discount factor for real k-period ahead payoffs
given by
o −1
Ct+k
t,t+k ≡ β k
(7)
Cto
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and where Qt is the (real) shadow value of capital in place, namely, Tobin’s Q.
Notice that, under our assumption on φ, the elasticity of the investment-capital
ratio with respect to Q is given by −1/φ (δ)δ ≡ η.21
We consider two alternative labor market structures. First we assume a
competitive labor market, with each household choosing the quantity of hours
supplied given the market wage. In that case the optimality conditions must be
supplemented with the first-order condition
Wt = Cto (Nto )ϕ . (8)
Under our second labor market structure wages are set in a centralized manner
by an economy-wide union. In that case hours are assumed to be determined by
firms (instead of being chosen optimally by households), given the wage set by
the union. Households are willing to meet the demand from firms, under the
assumption that wages always remain above all households’ marginal rate of
substitution. In that case condition (8) no longer applies. We refer the reader to
Section 3.6 and Appendix A for a detailed description of the labor market under
this alternative assumption.
Rule-of-thumb households. Rule-of-thumb households are assumed to behave

in a “hand-to-mouth” fashion, fully consuming their current labor income. They
do not smooth their consumption path in the face of fluctuations in labor income,
nor do they intertemporally substitute in response to changes in interest rates.
As noted we do not take a stand on the sources of that behavior, though one
may possibly attribute it to a combination of myopia, lack of access to financial
markets, or (continuously) binding borrowing constraints.
Their period utility is given by
U (Ctr , Lrt ), (9)
and they are subject to the budget constraint
Pt Ctr = Wt Pt Ntr − Pt Ttr . (10)
Accordingly, the level of consumption will equate labor income net of taxes:
Ctr = Wt Ntr − Ttr . (11)
Notice that we allow taxes paid by rule-of-thumb households (Ttr ) to dif-

fer from those of the optimizing households (Tto ). Under the assumption of a
21. See Basu and Kimball (2003) for a critical assessment of the predictions of new Keynesian
models with endogenous capital accumulation and a proposal for reconciling those predictions with
some of the evidence, based on the notion of costly investment planning.
“zwu001070405” — 2007/1/24 — page 238 — #12

competitive labor market, the labor supply of rule-of-thumb households must

satisfy
Wt = Ctr (Ntr )ϕ . (12)
Alternatively, when the wage is set by a union, hours are determined by firms’
labor demand, and (8) does not apply. Again we refer the reader to the subsequent
discussion.
Aggregation. Aggregate consumption and hours are given by a weighted average

of the corresponding variables for each consumer type. Formally,
Ct ≡ λCtr + (1 − λ)Cto (13)
and
Nt ≡ λNtr + (1 − λ)Nto . (14)
Similarly, aggregate investment and the capital stock are given by
It ≡ (1 − λ)Ito
and
Kt ≡ (1 − λ)Kto .
3.2. Firms
We assume a continuum of monopolistically competitive firms producing dif-

ferentiated intermediate goods. The latter are used as inputs by a (perfectly
competitive) firm producing a single final good.
Final goods firm. The final good is produced by a representative, perfectly

competitive firm with a constant returns technology:
εp
1 εp −1 εp −1
Yt = Xt (j ) εp
dj ,
0
where Xt (j ) is the quantity of intermediate good j used as an input and εp > 1.

Profit maximization, taking as given the final goods price Pt and the prices for
the intermediate goods Pt (j ), all j ∈ [0, 1], yields the set of demand schedules

Pt (j ) −εp
Xt (j ) = Yt ,
Pt
“zwu001070405” — 2007/1/24 — page 239 — #13

as well as the zero-profit condition

1
1 1−εp
Pt = Pt (j )1−εp dj .
0
Intermediate goods firm. The production function for a typical intermediate

goods firm (say, the one producing good j ) is given by
Yt (j ) = Kt (j )α Nt (j )1−α , (15)
where Kt (j ) and Nt (j ) represent the capital and labor services hired by firm j .22
Cost minimization, taking the wage and the rental cost of capital as given, implies

Kt (j ) α Wt
= .
Nt (j ) 1−α Rtk
Real marginal cost is common to all firms and given by
MCt = (Rtk )α (Wt )1−α ,
where ≡ α −α (1 − α)−(1−α) .
Price setting. Intermediate firms are assumed to set nominal prices in a stag-
gered fashion, according to the stochastic time dependent rule proposed by Calvo
(1983). Each firm resets its price with probability 1−θ each period, independently
of the time elapsed since the last adjustment. Thus, each period a measure 1 − θ
of producers reset their prices, while a fraction θ keep their prices unchanged.
A firm resetting its price in period t will seek to solve
∞

max
∗
Et θ k Et t,t+k Yt+k (j ) (Pt∗ /Pt+k ) − MCt+k ,
Pt
k=0
subject to the sequence of demand constraints
Yt+k (j ) = Xt+k (j ) = (Pt∗ /Pt+k )−εp Yt+k ,
and where Pt∗ represents the price chosen by firms resetting prices at time t.
The first-order condition for this problem is
∞

θ k Et t,t+k Yt+k (j ) (Pt∗ /Pt+k ) − µp MCt+k = 0, (16)
k=0
22. Without loss of generality we normalize total factor productivity to unity.
“zwu001070405” — 2007/1/24 — page 240 — #14

where µp ≡ εp /(εp − 1) is the gross “frictionless” price markup, and the one
prevailing in a zero inflation steady state. Finally, the equation describing the
dynamics for the aggregate price level is given by
1
Pt = θPt−1 p + (1 − θ )(Pt∗ )1−εp
1−ε 1−εp
. (17)
3.3. Monetary Policy
In our baseline model the central bank is assumed to set the nominal interest rate
rt ≡ Rt − 1 every period according to a simple linear interest rate rule:
r t = r + φ π πt , (18)
where φπ ≥ 0 and r is the steady state nominal interest rate. An interest rate
rule of the form (18) is the simplest specification in which the conditions for
indeterminacy and their connection to the Taylor principle can be analyzed. Notice
that it is a particular case of the celebrated Taylor rule (1993), corresponding to
a zero coefficient on the output gap, and a zero inflation target. Rule (18) is said
to satisfy the Taylor principle if and only if φπ > 1. As is well known, in the
absence of rule-of-thumb consumers, that condition is necessary and sufficient to
guarantee the uniqueness of equilibrium.23
3.4. Fiscal Policy
The government budget constraint is

Pt Tt + Rt−1 Bt+1 = Bt + Pt Gt , (19)
where Tt ≡ λ Ttr + (1 − λ) Tto . Letting gt ≡ (Gt − G)/Y , tt ≡ (Tt − T )/Y , and
bt ≡ ((Bt /Pt−1 ) − (B/P ))/Y , we henceforth assume a fiscal policy rule of the
form
tt = φb bt + φg gt , (20)
where φb and φg are positive constants.
Finally, government purchases (in deviations from steady state, and normal-
ized by steady state output) are assumed to evolve exogenously according to a
first order autoregressive process
gt = ρg gt−1 + εt , (21)
23. The “Taylor principle” refers to a property of interest rate rules for which an increase in inflation
eventually leads to a more than one-for-one rise in the nominal interest rate (see Woodford 2003).
“zwu001070405” — 2007/1/24 — page 241 — #15

where 0 < ρg < 1, and εt represents an i.i.d. government spending shock with
constant variance σε2 .
3.5. Market Clearing
The clearing of factor and good markets requires that the following conditions
are satisfied for all t:
1
Nt = Nt (j ) dj, Yt (j ) = Xt (j ) for all j ,
0
1
Kt = Kt (j ) dj, Yt = Ct + It + Gt . (22)
0
3.6. Linearized Equilibrium Conditions
In the present section we derive the log-linear versions of the key optimality and
market-clearing conditions that will be used in our analysis of the model’s equilib-
rium dynamics. Some of these conditions hold exactly, whereas others represent
first-order approximations around a zero-inflation steady state. Henceforth, and
unless otherwise noted, lower-case letters denote log-deviations with respect to
the corresponding steady state values (i.e., xt ≡ log Xt /X).
Households. Next we list the log-linearized versions of the defined households’

optimality conditions, expressed in terms of the aggregate variables. The log-
linear equations describing the dynamics of Tobin’s Q and its relationship with
investment are given respectively by
qt = βEt {qt+1 } + [1 − β(1 − δ)]Et {rt+1

k
} − (rt − Et {πt+1 }) (23)
and
it − kt = ηqt . (24)
The log-linearized capital accumulation equation is
kt+1 = δit + (1 − δ)kt . (25)
The log-linearized Euler equation for optimizing households is given by
cto = Et {ct+1
o
} − (rt − Et {πt+1 }) . (26)
“zwu001070405” — 2007/1/24 — page 242 — #16

Consumption for rule-of-thumb households is given, to a first order approx-

imation, by

WNr Y
ctr = (wt + n r
t ) − tr, (27)
Cr Cr t
where ttr ≡ (Ttr − T r )/Y .
As shown in the Appendix B, the analysis is simplified by assuming that
steady state consumption is the same across household types, that is, C r = C o =
C, an outcome that can always be guaranteed by an appropriate choice of T r and
T o . Because the focus of our paper is on the differential responses to shocks, as
opposed to steady state differences across households, we view that assumption
as being largely innocuous, while simplifying the algebra considerably.24 In par-
ticular, under the above assumption, the log-linearized expressions for aggregate
consumption and hours take the following simple form:
ct = λctr + (1 − λ)cto , (28)
nt = λnrt + (1 − λ)not . (29)
Under perfectly competitive labor markets, we can log-linearize expressions
(8) and (12) and combine them with (28) and (29) to obtain
wt = ct + ϕnt . (30)
Under the assumption of imperfectly competitive labor markets, one can
also interpret equation (30) as a log-linear approximation to a generalized wage
schedule of the form Wt = H (Ct , Nt ). In that case, and under the assumption that
each firm decides how much labor to hire (given the wage), firms will allocate labor
demand uniformly across households, independently of their type. Accordingly,
we will have Ntr = Nto for all t.25 In Appendix A we show how a wage schedule
of that form arises in an economy in which wages are set by unions in order to
maximize a weighted average of the utility of both types of households.
Independently of the assumed labor market structure we can derive an
intertemporal equilibrium condition for aggregate consumption of the form
ct = Et {ct+1 } − σ (rt − Et {πt+1 }) − n Et {nt+1 } + τ Et {tt+1
r
}. (31)
24. Notice that under perfectly competitive labor markets marginal rates of substitution are equal-
ized across households. The assumption of equal consumption levels in the steady state thus implies
that N r = N o = N as well. As discussed below, under our alternative labor market structure equal-
ity of hours across household types holds independently of their relative level of consumption. See
Appendix A for details.
25. We implicitly assume that the resulting wage markup is sufficiently high (and fluctuations
ϕ
sufficiently small) that the inequalities H (Ct , Nt ) > Ctj Nt for j = r, o are satisfied at all times.
Both conditions guarantee that both type of households will be willing to meet firms’ labor demand
at the prevaling wage. Notice also that consistency with balanced-growth requires that H can be
written as Ct h(Nt ) (which happens to be consistent with [30]).
“zwu001070405” — 2007/1/24 — page 243 — #17

In the case of perfectly competitive labor markets, the previous equa-

tion results from combining equations (8), (12), (26), (27), (28), and (29), the
associated coefficients are given by
σ ≡ (1 − λ)[µp ϕγc + (1 − α)],

n ≡ λ(1 − α)(1 + ϕ)ϕ,
t ≡ λµp ϕ,
where ≡ (µp ϕγc + (1 − α)(1 − λ(1 + ϕ)))−1 , and γc ≡ C/Y is the steady state
consumption-output ratio (which, does not depend on λ, as shown in Appendix B).
See Appendix C for details of the derivation.
By contrast, under the assumption of an imperfectly competitive labor market,
(31) can be derived from combining equations (30), (26), (27), (28), (29), as well
as the assumption nrt = not = nt . In that case the expressions for the coefficients
in (31) are given by
σ ≡ (1 − λ)γc µp ,
n ≡ λ(1 − α)(1 + ϕ),
t ≡ λµp ,
where ≡ (γc µp − λ(1 − α))−1 .

Notice that independently of the labor market structure assumed we have
limλ→0 σ = 1, limλ→0 n = 0, and limλ→0 τ = 0—that is, as the fraction
of rule-of-thumb consumers becomes negligible, the aggregate Euler equation
approaches its standard form given our utility specification.
Discussion. A number of features of these equilibrium conditions are worth

stressing. First, notice that the Euler equation (31) is the only log-linear equilib-
rium condition involving aggregate variables which displays a dependence on λ,
the fraction of rule-of-thumb households.
Second, the presence of rule-of-thumb households generates a direct effect
of employment on the level of consumption (and, thus, on aggregate demand),
beyond the effect of the long-term interest rate. This can be seen by “integrating”
(31) to obtain the following expression in levels:
∞

ct = n nt − τ ttr − σ Et {rt+k − πt+k+1 }.
k=0
Thus, for any given path of real interest rates and taxes, an expansion in
government purchases has the potential to raise aggregate consumption through
its induced expansion in employment and the consequent rise in the real wage,
“zwu001070405” — 2007/1/24 — page 244 — #18

labor income and, as a result, consumption of rule-of-thumb households. In turn,

the resulting increase in consumption would raise aggregate demand, output, and
employment even further, thus triggering a multiplier effect analogous to the one
found in traditional Keynesian models.
Third, the ultimate effect of government purchases on aggregate consumption
depends on the response of taxes (accruing to rule-of-thumb households) and the
expected long-term real rate. Those responses will, in turn, be determined by
the fiscal and monetary policy rules in place. Nevertheless, it is clear from the
previous equation that in order for aggregate consumption to increase in response
to a rise in government spending, the response of taxes and interest rates should be
sufficiently muted. We return to this point below, when analyzing the sensitivity
of our results to alternative calibrations of those policies.
Firms. Log-linearization of (16) and (17) around the zero inflation steady state
yields the familiar equation describing the dynamics of inflation as a function of
the log deviations of the average markup from its steady-state level
p
πt = βEt {πt+1 } − λp µ̂t , (32)
where λp = (1 − βθ)(1 − θ)θ −1 and, ignoring constant terms,

p
µ̂t = (yt − nt ) − wt , (33)
or, equivalently,
p
µ̂t = (yt − kt ) − rtk . (34)
Furthermore, as shown in Woodford (2003), the following “aggregate

production function” holds, up to a first-order approximation:
yt = (1 − α)nt + αkt . (35)
Market clearing. Log-linearization of the market-clearing condition of the final

good around the steady state yields
yt = γc ct + γi it + gt , (36)
where γi ≡ I /Y represents the share of investment on output in the steady state.
Fiscal policy. Linearization of the government budget constraint (19) around a

steady state with zero debt and a balanced primary budget yields
bt+1 = (1 + ρ)(bt + gt − tt ),
“zwu001070405” — 2007/1/24 — page 245 — #19

where ρ ≡ β −1 − 1 pins down the steady state interest rate. Plugging in the fiscal
policy rule previously assumed, we obtain
bt+1 = (1 + ρ)(1 − φb )bt + (1 + ρ)(1 − φg )gt . (37)
Hence, under our assumptions, a necessary and sufficient condition for non-
explosive debt dynamics is given by (1 + ρ)(1 − φb ) < 1, or equivalently
ρ
φb > .
1+ρ
4. Analysis of Equilibrium Dynamics
Combining all the equilibrium conditions and doing some straightforward, though
tedious, substitutions we can obtain a system of stochastic difference equations
describing the log-linearized equilibrium dynamics of the form
AEt {xt+1 } = Bxt + εt , (38)
where xt ≡ (nt , ct , πt , kt , bt , gt−1 ) . The elements of matrices A and B are all

functions of the underlying structural parameters, as shown in Appendix C. We
start by describing the calibration that we use as a benchmark.
Each period is assumed to correspond to a quarter. We set the discount factor
β equal to 0.99. We assume a steady state price markup µp equal to 0.2. The rate
of depreciation δ is set to 0.025. The elasticity of output with respect to capital,
α, is assumed to be 1/3, a value roughly consistent with observed income shares,
given the assumed steady state price markup. All the previous parameter values
remain unchanged in the analysis below. Next we turn to the parameters for which
we conduct some sensitivity analysis, distinguishing between the non-policy and
the policy parameters.
Our baseline setting for the weight of rule-of-thumb households λ is 1/2.
This is within the range of estimated values in the literature of the weight of the
rule-of-thumb behavior (see Mankiw 2000). The fraction of firms that keep their
prices unchanged, θ, is given a baseline value of 0.75, which corresponds to an
average price duration of one year. We set the baseline value for the elasticity of
wages with respect to hours (ϕ) equal to 0.2. This is consistent with Rotemberg
and Woodford’s (1997, 1999) calibration of the elasticity of wages with respect to
output of 0.3 combined with an elasticity of output with respect to hours of 2/3.
Finally, we follow King and Watson (1996), and set η (the elasticity of investment
with respect to q) equal to 1.0 in our baseline calibration.
The baseline policy parameters are chosen as follows. We set the size of the
response of the monetary authority to inflation, φπ , to 1.5, a value commonly used
in empirical Taylor rules (and one that satisfies the so-called Taylor principle).
“zwu001070405” — 2007/1/24 — page 246 — #20

In order to calibrate the parameters describing the fiscal policy rule (20) and
the government spending shock (21) (i.e., φg , φb , and ρg ) we use the VAR-
based estimates of the dynamic responses of government spending and deficit
(see Table 1 for details). In particular, we set the baseline value of the parameter
ρg = 0.9 that matches the half-life of the responses of government spending. The
latter value reflects the highly persistent response of government spending to its
own shock. We obtain the values of the parameter φg from the difference between
the estimated impact responses of government spending and deficit, respectively.
As can be seen from Table 1, our (average) estimates suggest a value for that
parameter equal to 0.10. Interestingly, the estimates in Table IV of Blanchard and
Perotti (2002) imply a corresponding estimate of 0.13, very much in line with our
estimates and baseline calibration. Given ρg and φg , we calibrate parameter φb
such that the dynamics of government spending (21) and debt (37) are consistent
with the horizon at which the deficit is back to zero in our estimates. Hence, in
our baseline calibration we set φb = 0.33, in line with the estimated averages for
different subsamples, as described in Table 1. Finally, we set γg = 0.2, which
roughly corresponds to the average share of government purchases in GDP in
postwar U.S. data.
Much of the sensitivity analysis below focuses on the share of rule-of-thumb
households (λ) and its interaction with parameters ρg , θ, η, ϕ, and φπ . Given
the importance of the fiscal rule parameters in the determination of aggregate
consumption (and, indirectly, of other variables) we will also analyze the effect
of alternative values for the policy parameters φb and φg .
4.1. Rule-of-Thumb Consumers, Indeterminacy, and the Taylor Principle
Next we provide a brief analysis of the conditions that guarantee the uniqueness
of equilibrium. A more detailed analysis of those conditions for an economy
similar to the one considered here (albeit without a fiscal block) can be found in
Galí, López-Salido, and Vallés (2004). In that paper we show how the presence
of rule-of-thumb consumers can alter dramatically the equilibrium properties of
an otherwise standard dynamic sticky price model. In particular, under certain
parameter configurations the economy’s equilibrium may be indeterminate (and
thus may display stationary sunspot fluctuations) even when the interest rate rule
is one that satisfies the Taylor principle (which corresponds to φπ > 1 in our
model).
Figure 2 illustrates that phenomenon for the model developed in the previous
section. In particular the figure displays the regions in (λ, θ ) space associated with
either a unique equilibrium or indeterminacy, when the remaining parameters are
kept at their baseline values. We see that indeterminacy arises whenever a high
degree of price stickiness coexists with a sufficiently large weight of rule-of-thumb
“zwu001070405” — 2007/1/24 — page 247 — #21

Figure 2. Determinacy analysis.

Note: Based on the model with competitive labor markets, remaining parameters at their baseline values. The dark area
corresponds to the indeterminacy region.
households. Both frictions are thus seen to be necessary in order for indeterminacy
to emerge as a property of the equilibrium dynamics. The figure also makes clear
that the equilibrium is unique under our baseline calibration (λ = 1/2, θ = 0.75).
We refer the reader to Galí, López-Salido, and Vallés (2004) for a discussion of
the intuition underlying that violation of the Taylor principle.26
26. See also Bilbiie (2005) for a subsequent analysis in a model without capital accumulation,
and for a re-assessment of the evolution of Fed policies over the postwar period, in light of that
analysis.
“zwu001070405” — 2007/1/24 — page 248 — #22

5. The Effects of Government Spending Shocks
In the present section we analyze the effects of shocks to government spending

in the model economy described above. In particular, we focus on the condi-
tions under which an exogenous increase in government spending has a positive
effect on consumption, as found in much of the existing evidence. Throughout we
restrict ourselves to configurations of parameter values for which the equilibrium
is unique.
Figure 3 shows the contemporaneous response of output, consumption, and
investment (all normalized by steady state output) to a positive government spend-
ing shock, as a function of λ, the fraction of rule-of-thumb consumers. The size of
the shock is normalized to a 1% of steady state output. Given our normalizations,
the plotted values can be interpreted as impact multipliers. We restrict the range of
λ values considered to those consistent with a unique equilibrium. The remaining
parameters are kept at their baseline values. Figure 3(A) corresponds to the econ-
omy with competitive labor markets, Figure 3(B) to its imperfectly competitive
counterpart. In the former case, consumption declines for most values of λ con-
sidered, except for implausible large ones. The (absolute) size of the decline is,
however, decreasing in λ, reflecting the offsetting role of rule-of-thumb behav-
ior on the conventional negative wealth and intertemporal substitution effects
triggered by the fiscal expansion. When imperfect labor markets are assumed,
the possibility of crowding-in of consumption emerges for values of λ above
a threshold value of roughly 1/4, a more plausible value. Notice also that the
government spending multiplier on inflation and output rises rapidly when λ
increases, attaining values roughly in line with the empirical evidence reviewed
in Section 2.
Figure 4 displays the dynamic responses of some key variables in our model
to a positive government spending shock under the baseline calibration, and com-
pares them to those generated by a neoclassical economy. The latter corresponds
to a particular calibration of our model, with no price rigidities and no rule-of-
thumb consumers (θ = λ = 0). Again we consider two alternative labor market
structures, competitive and non-competitive. In each case the top-left graph dis-
plays the pattern of the three fiscal variables (spending, taxes, and the deficit) in
response to the shock considered. Notice that the pattern of both variables is close
to the one estimated in the data (see Figure 1), consistently with our calibration of
the fiscal policy rule. The figure illustrates the amplifying effects of the introduc-
tion of rule-of-thumb consumers and sticky prices: The response of output and
consumption is systematically above that generated by the neoclassical model.27
27. That monotonicity contrasts with some of the patterns observed in the data; we conjecture this
is unrelated to the issue at hand and could be fixed by the introduction of habit formation and other
mechanisms that generate inertia in aggregate demand.
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Figure 3. Impact multipliers: sensitivity to λ.

Note: Baseline calibration for remaining parameters.
“zwu001070405” — 2007/1/24 — page 250 — #24

Figure 4. The dynamic effects of a government spending shock: baseline vs. neoclassical models.
Note: Baseline calibration (continuous), neoclassical calibration (dashed).
“zwu001070405” — 2007/1/24 — page 251 — #25

Figure 5. Impact multipliers: sensitivity to ρg , alternative calibrations. (Non-competitive labor

market).
Furthermore, in the baseline model, and in contrast with the neoclassical model,
the increase in aggregate hours coexists with an increase in real wages. Overall
we view the model’s predictions under the assumption of imperfectly competitive
labor markets as matching the empirical responses, at least qualitatively.
Figure 5 shows the government spending (impact) multipliers on output,
consumption, and investment, as a function of ρg , the parameter measuring the
persistence of the spending process. In order to avoid excessive dispersion, we
henceforth report findings only for the non-competitive labor market specifi-
cation, which the analysis above pointed to as the most promising one given
our objectives. Each of the four graphs in the figure corresponds to a differ-
ent parameter configuration. The top-left graph is associated with our baseline
calibration. Notice that that in that case the crowding-in effect on consumption
“zwu001070405” — 2007/1/24 — page 252 — #26

(and the consequent enhancement of the output multiplier) is decreasing in ρg .

The intuition for that result is straightforward: Higher values of that parameter
are associated with stronger (negative) wealth effects lowering the consumption
of Ricardian households. Yet we see that even for values of ρg as high as 0.9
a positive (though relatively small) effect on aggregate consumption emerges.
Notice also that the response of investment to the same shock is negative over
the admissible range of ρg . For values of the latter parameter close to unity (i.e.,
near-random walk processes for government spending) that response becomes
negligible.28
The other graphs in Figure 5 report analogous information for three alternative
“extreme” calibrations. Each calibration assumes a limiting value for one (or two)
parameters, while keeping the rest at their baseline values. Thus, the flexible price
scenario assumes θ = 0, the no rule-of-thumb economy assumes λ = 0, and
the neoclassical calibration combines both flexible prices and lack of rule-of-
thumb consumers (θ = λ = 0). Notice that when prices are fully flexible, or
when all consumers are Ricardian (or when both features coexist, as under the
neoclassical calibration) consumption is always crowded out in response to a rise
in government spending, independently of the degree of persistence of the latter.
This illustrates the difficulty of reconciling the evidence with standard dynamic
general equilibrium models, as well as the role played by both sticky prices and
rule-of-thumb consumers to match that evidence.
The graphs in Figure 6 summarize the sensitivity of the impact multipliers
to variations in three non-policy parameters to the government spending shock.
The first graph explores the sensitivity of the impact multipliers to the degree of
price stickiness, as indexed by parameter θ. Notice that the size of the response
of output is increasing in the degree of price rigidities, largely as a result of a
stronger multiplier effect on consumption. Given baseline values for the remaining
parameters, we see that values of θ slightly higher than 0.5 are consistent with a
positive response of aggregate consumption. That range for θ includes the values
generally viewed as consistent with the micro evidence and, hence, used in most
calibrations. The two middle and bottom graphs show the impact multipliers
when the degree of capital adjustment costs, η, and the wage elasticity parameter,
ϕ change. High capital adjustment costs (i.e., low η) tend to dampen the fall in
investment but enhance the positive response of consumption and output. Finally,
we notice that the impact multipliers are relatively insensitive to changes in ϕ.
Figure 7 illustrates the sensitivity of the model’s predictions to the three
policy parameters (φπ ,φg , φb ), each considered in turn. The top graph shows an
inverse relationship between the size of the impact multipliers and the strength
28. As shown subsequently, the response of investment depend crucially upon the specification of
capital adjustment costs. Lower capital adjustment costs tend to increase the (negative) response of
investment (see middle panel of Figure 6).
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Figure 6. Impact multipliers: sensitivity to non-policy parameters (θ, ϕ, η).
“zwu001070405” — 2007/1/24 — page 254 — #28

of the central bank’s response to inflation (φπ ). Intuitively, a large φπ leads to

a larger increase in the real rate in response to the higher inflation induced by
the fiscal expansion; as a result consumption of Ricardian households declines
further, dampening the total effect on aggregate consumption. That finding should
not be surprising once we realize that in staggered price setting models like ours
the central bank can approximate arbitrarily well the flexible price equilibrium
allocation by following an interest rate rule that responds with sufficient strength to
changes in inflation. Hence, an increase in φπ affects the output and consumption
multipliers in a way qualitatively similar to an increase in price flexibility (i.e., a
decline in θ), as described previously.
Finally, the second and third graphs show the sensitivity of the multiplier
to variations in the two parameters of the fiscal rule. In particular, and of most
interest given our objectives, we see how a positive comovement of consumption
and output in response to government spending shocks requires a sufficiently
high response of taxes to debt (a high φb ), and a sufficiently low response of taxes
to current government spending (i.e., a low φg ). Such a configuration of fiscal
parameters will tend to imply a large but not-too-persistent deficit in response to an
increase in government spending, a pattern largely consistent with the empirical
evidence described in Section 2.
6. Rule-of-Thumb Consumers vs. Non-Separable Preferences
In this section we discuss an alternative potential explanation for our evidence

of a positive response of consumption to a rise in government spending: The
presence of non-separable preferences in utility an leisure. In particular, Basu and
Kimball (2002) bring up that possibility as an explanation for the significance of
anticipated disposable income in the consumption Euler equation estimated by
Campbell and Mankiw (1989). We point to an aspect of the model with rule-of-
thumb consumers which allows us to differentiate it, at least in principle, from
one with non-separable preferences.
To see this formally consider the following specification of period utility:
1
(Ct (1 − Nt )χ )1− σ
U (Ct , Nt ) = , (39)
1 − σ −1
where parameter σ > 0 represents the elasticity of intertemporal substitution for

consumption and χ ≥ 0. Under the previous utility specification the log-linear
approximation to the consumption Euler equation of a Ricardian household can
be shown to take the form (see, e.g., Basu and Kimball 2002)
ct = Et {ct+1 } − σ (rt − Et {πt+1 }) − (1 − σ ) Et {nt+1 }, (40)
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Figure 7. Impact multipliers: sensitivity to policy parameters (φπ , φg , φb ).
“zwu001070405” — 2007/1/24 — page 256 — #30

where ≡ χN (1 − N )−1 > 0. When σ = 1, preferences are separable and

hours drop out of (41). Otherwise, anticipated movements in hours should have
predictive power for consumption growth. The previous optimality equation can
be rewritten as
ct+1 = σ (rt − Et {πt+1 }) + (1 − σ ) Et {nt+1 } + ξt+1 , (41)
where ξt+1 ≡ ct − Et {ct+1 } is the unpredictable component of consumption.

Notice that (41) can be estimated using an IV estimator, by replacing Et {πt+1 }
and Et {nt+1 } with their realized counterparts, πt+1 and nt+1 , and using lagged
variables as instruments.
Notice also that (41) has a structure similar to
ct+1 = σ (rt − Et {πt+1 }) + λEt {ydt+1 } + ξt+1 , (42)
where ydt denotes (log) disposable income. Campbell and Mankiw (1989) used
a version of (42) to test the permanent income hypothesis (PIH), and interpreted
coefficient λ as the fraction of aggregate consumption corresponding to rule-of-
thumb consumers. Their finding of a large and significant λ (with a point estimate
close to 0.5), led them to reject the PIH in favor of a model with borrowing
constraints or myopic behavior.
As stressed by Basu and Kimball (2002), however, Campbell and Mankiw’s
interpretation of their results hinges on the assumption of a utility that is sepa-
rable in consumption. If preferences are instead given by (39) (with σ = 1), a
common interpretation of their results as suggesting that a substantial fraction of
U.S. consumers behave in a non-Ricardian fashion may not be warranted. The
reason is simple: Given the high positive correlation between changes in (log)
disposable income and changes in (log) hours, it is clear that a researcher esti-
mating (42) would easily conclude that anticipated changes in disposable income
have predictive power for consumption growth (i.e., a significant λ), even if all
consumers were fully Ricardian (as long as utility was non-separable). Further-
more, the positive estimate for λ obtained by Campbell and Mankiw would be
consistent with a low intertemporal elasticity of substitution (σ < 1).
The problem of near-observational equivalence between the two hypotheses,
and the likely multicollinearity that the joint use of changes in hours and dispos-
able income would imply, led Basu and Kimball (2002) to estimate a restricted
version of (41). In particular, and using the fact that the household’s intratemporal
optimality condition implies that ≡ χ N(1 − N)−1 = W N/P C, a ratio which
is in principle observable, they rewrite (41) as
(ct+1 − 0.8Et {nt+1 }) = σ (rt − Et {πt+1 } − 0.8Et {nt+1 })

+ λEt {ydt+1 } + ξt+1 , (43)
“zwu001070405” — 2007/1/24 — page 257 — #31

where the choice of 0.8 as a setting for corresponds the average ratio of labor
income to consumption expenditures in the postwar U.S. Under the joint null
of fully Ricardian consumers and non-separable preferences we have λ = 0, a
hypothesis that they cannot reject using aggregate postwar data, thus calling into
question the interpretation that Campbell and Mankiw gave to their findings.
Clearly, optimality condition (40) has some similarities with equation (31),
reproduced here for convenience, which results in our model from combining the
Euler equation of Ricardian households (endowed with separable preferences)
with the budget constraint of rule-of-thumb households:
ct = Et {ct+1 } − σ (rt − Et {πt+1 }) − n Et {nt+1 } + τ Et {tt+1
r
},
where n and τ , defined earlier in the text, are positive as long as there is some
mass of rule-of-thumb consumers (and zero otherwise).
Notice however, one important difference between the two equations: In
the model with rule-of-thumb consumers anticipated changes in taxes (minus
transfers) accruing to those consumers should have predictive power for con-
sumption growth, once we control for the influence of the interest rate and hours
growth. That feature, on the other hand, is absent from the Euler equation in the
Basu-Kimball model with Ricardian households and non-separable preferences.
We interpret the existing evidence on the response of consumption to antic-
ipated changes in taxes as bearing directly on this issue. Thus, using household
level data, Parker (1999) finds evidence of a large response of consumption to
variations in after-tax income resulting from anticipated changes in Social Secu-
rity taxes, with the estimated elasticity being close to one half. Similarly, Souleles
(1999) finds evidence of excess sensitivity of households’ consumption to pre-
dictable income tax refunds, with the implied marginal propensity to consume
the tax refunds between 0.35 and 0.60. Similar results are uncovered by Johnson
et al. (2004), focusing on the income tax rebate of 2001. None of those anticipated
changes in taxes should have effect on consumption in a fully Ricardian model,
independently of whether preferences are separable in consumption and labor
or not.
Here we complement the evidence based on household data just discussed
with our own evidence, using quarterly aggregate U.S. time series. To set the
stage, we first re-estimate the Campbell-Mankiw Euler equation (42) using an
updated data set, running from 1954:I to 2004:IV. We use as instruments second
and third lags of the interest rate, changes in (log) consumption, and changes in
(log) hours. A detailed description of the data and sources can be found in the
footnote to Table 2.
Our estimates of the Campbell-Mankiw model, shown in the top panel of
Table 2, confirm the earlier findings of those authors. Most importantly, (antici-
pated) change in (log) disposable income are shown to have predictive power for
consumption changes, with the point estimate of λ being close to 0.5 and, hence,
“zwu001070405” — 2007/1/24 — page 258 — #32

Table 2. Estimates of the consumption Euler equation.

Regressors
Specification rt−1 − πt nt ytd taxt
Campbell-Mankiw .076 – .477* –
(.073) (0.103)
Basu-Kimball
(1) .314* .549* – –
(.066) (.053)
(2) .317* .546* −.176 –
(.076) (.061) (.209)
(3) .201* .639* – −.061*
(.051) (.086) (.023)
Note: Standard errors in brackets. The instruments include the real interest rate, (per capita) consumption growth and
(per capita) hours worked growth at t − 2 and t − 3, and in the last two columns the rate of growth of disposable income or
taxes between t − 2 and t − 3, respectively. Consumption growth is defined as non-durable plus services (CNH + CSH),
the real interest rate (r − π) is constructed using the 3-month TBill rate (FTB3) minus the rate of growth of personal
consumption deflator—defined as the ratio between nominal and real consumption ((CN + CS)/(CNH + CSH)). Per
capita hours (n) correspond the Non-Farm Business Sector (LXNFH). The real personal disposable income (y d ) is from
the FRED II, and from the BEA we define the variable tax as the difference between Government Current Tax Receipts
(GRCRT) and Government Current Transfer Payments (GETFP) divided by potential output (GDPPOTQ) at t − 1.
*Significant at 5% level.
of the same order of magnitude as the original Campbell-Mankiw estimates. In

addition, the estimates uncover no evidence of any intertemporal substitution
effects, as reflected in the insignificant estimate of the interest rate coefficient.
The second panel of Table 2 reports the IV estimates of alternative versions
of the Basu-Kimball Euler equation (43), imposing the steady state restrictions
implied by the theory. Row (1) shows the estimates of (43), excluding changes in
disposable income (λ = 0). In contrast with the findings based on the Campbell-
Mankiw equation, the estimate of the intertemporal elasticity of substitution (the
coefficient on interest rate) is now significantly different from zero, with a point
estimate close 0.3. In addition, as shown in row (2) once changes in hours are
properly controlled for, (anticipated) changes in disposable income lose their
explanatory power for consumption changes, thus replicating the main finding in
Basu and Kimball (2002).
In row (3) we introduce changes in taxes as an explanatory variable in the same
IV equation, substituting disposable income, and motivated by the predictions of
the model with rule-of-thumb consumers. Because we have no way to isolate
taxes paid by non-Ricardian households, we use instead a measure of overall net
taxes given by the difference between government current tax receipts (GRCRT)
and government current transfer payments (GETFP), divided by (lagged) poten-
tial output (GDPPOTQ).29 Under the null implied by the Ricardian model with
29. See Table 2 for details on the definition of the variables. Tax data were drawn from the BEA
Web page (http://www.bea.gov).
“zwu001070405” — 2007/1/24 — page 259 — #33

non-separable utility, no variable other than the (hours-adjusted) real interest

rate should have predictive power for (hours-adjusted) consumption changes, as
implied by (43) with λ = 0. Yet, as shown in Table 2, anticipated changes in (net)
taxes enter the Euler equation significantly (and with the expected sign). The
estimated elasticity of intertemporal substitution remains significant, though its
point estimate has been reduced to 0.2. We interpret the evidence of the predictive
power of tax changes on consumption as a rejection of a fully Ricardian model
with non-separable preferences, and one that is at least suggestive of the presence
of non-Ricardian households, in accordance with the micro evidence reviewed
earlier.
7. Concluding Comments and Further Research
The analysis herein has shown how the interaction between rule-of-thumb behav-
ior by some households (for which consumption equals labor income) and sticky
prices (modeled as in the recent new Keynesian literature) make it possible to gen-
erate an increase in consumption in response to a rise in government spending,
in a way consistent with much of the recent evidence. Rule-of-thumb consumers
partly insulate aggregate demand from the negative wealth effects generated by
the higher levels of (current and future) taxes needed to finance the fiscal expan-
sion, while making it more sensitive to current disposable income. Sticky prices
make it possible for real wages to increase (or, at least, to decline by a smaller
amount) even in the face of a drop in the marginal product of labor, as the price
markup may adjust sufficiently downward to absorb the resulting gap. The com-
bined effect of a higher real wage and higher employment raises current labor
income and hence stimulates the consumption of rule-of-thumb households. The
possible presence of countercyclical wage markups (as in the version of the model
with non-competitive labor markets developed above) provides additional room
for a simultaneous increase in consumption and hours and, hence, in the marginal
rate of substitution, without requiring a proportional increase in the real wage.
Perhaps most importantly, our framework generates a positive comovement
of consumption and government spending under configurations of parameter val-
ues that are empirically plausible (and conventionally assumed in the business
cycle literature). Thus, we view our results as providing a potential solution to
the seeming conflict between empirical evidence and the predictions of existing
DSGE models regarding the effects of government spending shocks.
In the present paper we kept both the model and its analysis as simple as
possible, and focused on a single issue. As a result, we left out many possible
extensions and avenues for further exploration. Thus, for instance, our theoretical
analysis assumes that government spending is financed by means of lump-sum
taxes (current or future). If only distortionary income taxes were available to the
“zwu001070405” — 2007/1/24 — page 260 — #34

government, the response of the different macroeconomic variables to a govern-

ment spending shock will generally differ from the one obtained in the economy
with lump-sum taxes analyzed above, and will generally depend on the compo-
sition and timing of taxation.30 Allowing for staggered nominal wage setting or
some form of real wage rigidity constitutes another potentially useful extension
of our framework, one that is likely to have a significant effect on the response of
real wages and, hence, of labor income and consumption to any fiscal shock.
Another avenue worth pursuing is the introduction of rule-of-thumb con-
sumers in medium-scale DSGE models of the sort developed by Smets and
Wouters (2003) and Christiano, Eichenbaum, and Evans (2005). Those models
incorporate many of the features that have been shown to be useful in account-
ing for different aspects of economic fluctuations, and which have been assumed
away in the model developed above. Such a richer version of our model could be
taken to the data, and generate estimates of the quantitative importance of rule-
of-thumb consumers and their role in shaping historical economic fluctuations.
Early examples of efforts in that direction can already be found in the work of
Coenen and Straub (2005), Erceg, Guerrieri, and Gust (2005), Forni, Monteforte,
and Sessa (2006), and López-Salido and Rabanal (2006).
A number of papers have documented a stronger interest rate response to
changes in inflation during the past two decades, relative to the pre-Volcker era.31
There is also substantial evidence pointing to a rise in asset market participation
over the postwar period, which in the context of our model could be interpreted as
a decline in the fraction of rule-of-thumb consumers. The model developed herein
predicts a reduction in the government spending multiplier on consumption and
output, in response to both developments. In that spirit, Bilbiie, Maier, and Müller
(2005) explore the implications of those changes in the context of a model similar
to ours, and suggest that those developments may explain part of the observed
decline in fiscal multipliers uncovered by Perotti (2004) and others.
Finally, one would want to consider some of the normative implications of
our framework: In a model with the two types of consumers considered herein,
the monetary and fiscal policy responses to shocks of different nature can be
expected to have distributional effects, which should be taken into account in
the design of those policies. Exploring the implications of the present model for
optimal monetary policy design constitutes an additional interesting avenue for
future research.32
30. An example of work in that direction is given by Bilbiie and Straub (2005), who study the
interaction of distortionary taxes and rule-of-thumb households, albeit in a model without capital
accumulation.
31. See, for example, Clarida, Galí, and Gertler (2000).
32. This is the road taken by Amato and Laubach (2003), albeit in the context of an alternative
model of rule-of-thumb behavior.
“zwu001070405” — 2007/1/24 — page 261 — #35

Appendix A: Alternative Labor Market Structures
In the present appendix we describe two alternative models of wage determination

that generate a log-linear aggregate equilibrium condition corresponding to (30)
in the text.
A.1. Perfectly Competitive Labor Markets
When households choose optimally their labor supply taking wages as given, the
intratemporal optimality condition takes the form
j j
Wt = Ct (Nt )ϕ ,
or, in logs,
j j
wt = ct + ϕnt , (A.1)
for j = r, o.
Notice that under our assumption of equality of steady state consumption
across household types, steady state hours will also be equated. Hence we can
write
nt = λnrt + (1 − λ)not ,
which, together with equations (28) and (A.1), allows us to obtain the aggregate
equilibrium condition
wt = ct + ϕnt .
A.2. Wage-Setting by Unions
Consider a model with a continuum of unions, each of which represents workers

of a certain type. Effective labor input hired by firm j is a CES function of the
quantities of the different labor types employed,
εw
1 εw −1
εw −1
Nt (j ) = Nt (j, i) εw di ,
0
where εw is the elasticity of substitution across different types of households.

The fraction of rule-of-thumb and Ricardian consumers is uniformly distributed
across worker types (and hence across unions). Each period, a typical union (say,
“zwu001070405” — 2007/1/24 — page 262 — #36

representing worker of type z) sets the wage for its workers in order to maximize
the objective function
1+ϕ 1+ϕ
1 Nt (z) 1 Nt (z)
λ r Wt (z)Nt (z) − + (1 − λ) o Wt (z)Nt (z) − ,
Ct (z) 1+ϕ Ct (z) 1+ϕ
subject to a labor demand schedule

−εw
Wt (z)
Nt (z) = Nt .
Wt
Because consumption will generally differ between the two types of con-
sumers, the union weighs labor income with their respective marginal utility of
consumption (i.e., 1/Ctr and 1/Cto ). Notice that, in writing down the problem,
we have assumed that the union takes into account the fact that firms allocate
labor demand uniformly across different workers of type z, independently of their
household type. It follows that, in the aggregate, we will have Ntr = Nto = Nt
for all t.
The first order condition of this problem can be written as follows (after
invoking symmetry, and thus dropping the z index)

λ 1−λ
+ Wt = µw , (A.2)
MRS rt MRS ot
ϕ ϕ
where MRS rt ≡ Ctr Nt , MRS ot ≡ Cto Nt , and µw ≡ εwεw−1 .
Log-linearizing expression (A.2) and ignoring constant terms yields the wage
schedule
wt = χr mrsrt + χo mrsot = c̃t + ϕ(χr + χo )nt ,
where χr ≡ λW/MRS r µw , χo ≡ (1 − λ)W/MRS o µw , and c̃t ≡ χr ctr + χo cto .

Notice that, to the extent that tax policy equates steady state consumption
across household types (i.e., C r = C o ) we will have MRS r = MRS o and, hence,
χr = λ and χo = 1 − λ. We can then rewrite the previous equilibrium condition
as
wt ≡ ct + ϕnt ,
which corresponds to the equation (30) in the text.

Under the present scenario we assume that the wage markup µw is sufficiently
j
large (and the shocks sufficiently small) so that the conditions Wt > MRS t for j =
r, o are satisfied for all t. Both conditions guarantee that both type of households
will be willing to meet firms’ labor demand at the prevailing wage.
“zwu001070405” — 2007/1/24 — page 263 — #37

Appendix B: Steady State Analysis
In this short appendix we show that the steady state ratio of aggregate consumption
to total output does not depend upon the fraction of rule-of-thumb consumers. In
doing so, we just notice that the market clearing condition for final goods implies
I G δα δα
γc = 1 − − = 1 − Y − γg = (1 − γg ) − ,
Y Y α K (ρ + δ) µp
where the last equality follows from the fact that in the steady state R k = αY /µp K
(implied by the constant marginal cost) and R k = (ρ + δ) (implied by a constant
Q). Notice that this share of consumption on total output it is independent of
the share of rule-of-thumb consumers and our assumption on the labor market
structure.
Appendix C: Derivation of the Reduced Dynamical System
The equilibrium conditions describing the model dynamics are given by expres-
sions (30)–(37). Now we reduce those conditions to the five variable system (38)
in terms of hours, consumption, inflation, capital, and government spending.
The first equation in the system (38) corresponds to the linearized capital accu-
mulation equation (25), with it substituted out using market-clearing condition
(36) and replacing yt subsequently using the production function (35):

δα δ(1 − α) δγc δ
kt+1 = 1−δ+ kt + nt − ct − gt , (C.1)
1 − γ̃c 1 − γ̃c 1 − γ̃c 1 − γ̃c
where γ̃c = γc + γg . In order to derive the second equation in (38) we start by

rewriting the inflation equation (32) in terms of variables contained in xt . Using
(33) and (30) we obtain an expression for the marginal cost as a function of the
consumption output ratio and aggregate hours:
µt = yt − ct − (1 + ϕ)nt . (C.2)
Substituting the previous expression (C.2) into (32), and making use of (35),
yields the second equation in (38):
πt = βEt {πt+1 } + λp [ct − yt + (1 + ϕ)nt ]

= βEt {πt+1 } + λp ct − αλp kt + (α + ϕ)λp nt . (C.3)
“zwu001070405” — 2007/1/24 — page 264 — #38

C.1. Aggregate Euler Equation: Perfectly Competitive Labor Markets
As noted, under the assumption of perfectly competitive labor markets, we can

log-linearize expressions (8) and (12) and combine them with (28) and (29)
to yield expression (30). From log-linearizing expression (12) we obtain an
expression for the evolution of the hours worked by the rule-of-thumb consumers:

nrt = ϕ −1 wt − ctr .
We now substitute the previous expression as well as (30) into expression (27).
After rearranging terms this yields ctr as a function only of aggregate variables:
[µp γc ϕ + (1 − α)]ctr
= (1 − α)(1 + ϕ)ct + (1 − α)(1 + ϕ)ϕnt − µp ϕttr . (C.4)
As noted before, we also apply the operator (1 − L−1 ) to expression (28),

which yields
ct − Et {ct+1 } = λ[ctr − Et {ct+1

r
}] + (1 − λ)[cto − Et {ct+1
o
}].
Finally, we substitute expressions (C.4) and (26) into the previous one, which
after rearranging terms, yields the Euler equation for aggregate consumption
presented in the main text:
1
ct = Et {ct+1 } − (rt − Et {πt+1 }) − n Et {nt+1 } + τ Et {tt+1
r
},
σ̃
where
1/σ̃ ≡ (1 − λ)[µp ϕγc + (1 − α)], n ≡ λ(1 − α)(1 + ϕ)ϕ,

−1
≡ γc µp ϕ + (1 − α)(1 − λ(1 + ϕ)) , t ≡ λµp ϕ.
C.2. Aggregate Euler Equation: Imperfectly Competitive Labor Markets
We first substitute expression (30) into expression (27), yielding

WN Y r
ctr = [ct + (1 + ϕ)nt ] − t
C C t
(1 − α) (1 − α)(1 + ϕ) 1
= p
ct + p
nt − ttr .
µ γc µ γc γc
“zwu001070405” — 2007/1/24 — page 265 — #39

We proceed to use the operator (1−L−1 ) in the previous expression, yielding
(1 − α)
ctr − Et {ct+1
r
}= [ct − Et {ct+1 }]
γc µp
(1 − α)(1 + ϕ) 1
+ p
[nt − Et {nt+1 }] − [ttr − Et {tt+1
r
}].
γc µ γc
(C.5)
We also apply the operator (1 − L−1 ) to expression (28), which yields
ct − Et {ct+1 } = λ[ctr − Et {ct+1

r
}] + (1 − λ)[cto − Et {ct+1
o
}].
Finally, we substitute expressions (C.5) and (26) into the previous one, which
after rearranging terms yields an Euler-like equation for aggregate consumption:
γc µp (1 − λ)
ct = Et {ct+1 } − (rt − Et {πt+1 })
γc µp − λ(1 − α)
λ(1 + ϕ)(1 − α) λµp
− E t {n t+1 } + Et {tt+1
r
},
γc µp − λ(1 − α) γc µp − λ(1 − α)
or, more compactly,
1
ct = Et {ct+1 } − (rt − Et {πt+1 }) − n Et {nt+1 } + t Et {tt+1
r
},
σ̃
where
1/σ̃ ≡ γc (1 − λ)µp , n ≡ λ(1 − α)(1 + ϕ),

−1
≡ γc µp − λ(1 − α) , t ≡ λµp ,
which are the coefficients of this expression in the text.

Plugging into the Euler equation the interest rate rule (18), the fiscal rule (20),
and using the fact the government spending follows a first order autoregressive
process (21) we obtain the third equation in (38):
φπ 1
c t − n nt + πt = Et {ct+1 } + Et {πt+1 } − n Et {nt+1 } (C.6)
σ̃ σ̃
+ t φb bt+1 + t φg (ρg − 1)gt .
In order to derive the fourth equation, we first combine (C.2) and (34) to
obtain rtk = ct − kt + (1 + ϕ)nt . The latter expression and the interest rate
“zwu001070405” — 2007/1/24 — page 266 — #40

rule (18), allows us to rewrite the equations describing the dynamics of Tobin’s
q and investment as follows:
it − kt = βEt {(it+1 − kt+1 )}

+ η[1 − β(1 − δ)] Et {ct+1 } − kt+1 + (1 + ϕ)Et {nt+1 }
− ηφπ πt + ηEt {πt+1 }.
Finally, substituting the relationship

1
i t − kt = (1 − α)nt − γc ct − gt − (1 − γ̃c − α)kt
1 − γ̃c
(which can be derived by combining the goods market-clearing condition with the
production function) into the previous equation and rearranging terms we obtain
the fourth equation of our dynamical system:
(1 − α)nt − γc ct − (1 − γ̃c − α)kt + (1 − γ̃c )ηφπ πt

= [ω(1 + ϕ) + β(1 − α)] Et {nt+1 } + (ω − βγc ) dEt {ct+1 }
−[ω + β(1 − γ̃c − α)]kt+1 + (1 − γ̃c )ηEt {πt+1 } + (1 − βρg )gt , (C.7)
where ω ≡ η[1 − β(1 − δ)](1 − γ̃c ) > 0.

The last two equations of the system correspond to expression (37) describ-
ing the debt accumulation and the autoregressive process for government
spending (21).
Hence the system of equations (C.1), (C.3), (C.6), (C.7), (37), and (21) can
be written in a matrix form as follows:
AEt {xt+1 } = Bxt + εt ,
where xt ≡ [nt , ct , πt , kt , bt , gt−1 ] , and

⎡ δ ⎤
0 0 0 1 0 1−γ̃c
⎢ ⎥
⎢ 0 0 β 0 0 0 ⎥
⎢ ⎥
⎢ −n 1 1
0 t φb t (ρg − 1)φg⎥
A ≡⎢
⎢
σ̃ ⎥,
⎥
⎢ω(1 + ϕ) + β(1 + α) ω − βγc (1 − γ̃c )η −[ω + β(1 − γ̃c − α)] 0 (1−βρg ) ⎥
⎢ ⎥
⎣ 0 0 0 0 1 −(1 + ρ)(1 − φg )⎦
0 0 0 0 0 1
“zwu001070405” — 2007/1/24 — page 267 — #41

⎡ δ(1−α) δγc ⎤
1−γ̃c − 1− γ̃c 0 1−δ+ δα
1−γ̃c 0 0
⎢ ⎥
⎢−(α + ϕ)λp −λp 1 αλp 0 0⎥
⎢ ⎥
⎢ −n 1 φπ
0 0⎥
B ≡⎢ ⎥.
σ̃ t φb
⎢ ⎥
⎢ 1−α −γc (1 − γ̃c )ηφπ γ̃c + α − 1 0 0⎥
⎢ ⎥
⎣ 0 0 0 0 (1 + ρ)(1 − φb ) 0⎦
0 0 0 0 0 ρg
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UNDERSTANDING THE EFFECTS

Jordi Galí Javier Vallés

What are the effects of changes in government purchases on aggregate economic

Journal of the European Economic Association March 2007 5(1):227–270

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Consider first an economy with a constant wedge, µt = µ for all t. Notice

2. An Overview of the Evidence

In the present section we start by summarizing the existing evidence on the

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uncover a large, positive, and significant response of consumption, others find

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Figure 1. The dynamic effects of a government spending shock.

Figure 1 displays the estimated impulse responses. Total government spend-

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Table 1. Estimated effects of government spending shocks.

macroeconometric models.11 Most important for our purposes is the observation

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a similar approach reports a flat response of aggregate consumption in the short

3. A New Keynesian Model with Rule-of-Thumb Consumers

The economy consists of two types of households, a continuum of firms producing

18. See Table 6 in Alesina and Ardagna (1998).

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We assume a continuum of infinitely lived households, indexed by i ∈ [0, 1].

subject to the sequence of budget constraints

Pt (Cto + Ito ) + Rt−1 Bt+1

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and the capital accumulation equation

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Wt = Cto (Nto )ϕ . (8)

Rule-of-thumb households. Rule-of-thumb households are assumed to behave

U (Ctr , Lrt ), (9)

and they are subject to the budget constraint

Pt Ctr = Wt Pt Ntr − Pt Ttr . (10)

Ctr = Wt Ntr − Ttr . (11)

Notice that we allow taxes paid by rule-of-thumb households (Ttr ) to dif-

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competitive labor market, the labor supply of rule-of-thumb households must

Wt = Ctr (Ntr )ϕ . (12)

Aggregation. Aggregate consumption and hours are given by a weighted average

Ct ≡ λCtr + (1 − λ)Cto (13)

Nt ≡ λNtr + (1 − λ)Nto . (14)

Similarly, aggregate investment and the capital stock are given by

We assume a continuum of monopolistically competitive firms producing dif-

Final goods firm. The final good is produced by a representative, perfectly

where Xt (j ) is the quantity of intermediate good j used as an input and εp > 1.

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as well as the zero-profit condition

Intermediate goods firm. The production function for a typical intermediate

MCt = (Rtk )α (Wt )1−α ,

subject to the sequence of demand constraints

Yt+k (j ) = Xt+k (j ) = (Pt∗ /Pt+k )−εp Yt+k ,

22. Without loss of generality we normalize total factor productivity to unity.

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3.3. Monetary Policy

3.4. Fiscal Policy

The government budget constraint is

σ ≡ (1 − λ)[µp ϕγc + (1 − α)],

where ≡ (γc µp − λ(1 − α))−1 .

ct = Et {ct+1 } − σ (rt − Et {πt+1 }) − (1 − σ ) Et {nt+1 }, (40)

ct+1 = σ (rt − Et {πt+1 }) + (1 − σ ) Et {nt+1 } + ξt+1 , (41)

ct+1 = σ (rt − Et {πt+1 }) + λEt {ydt+1 } + ξt+1 , (42)

(ct+1 − 0.8Et {nt+1 }) = σ (rt − Et {πt+1 } − 0.8Et {nt+1 })