A Model of the Confidence Channel of Fiscal Policy

Abstract

This article presents a simple macroeconomic model where government spending affects aggregate demand directly and indirectly, through an expectational channel. Prices are fully flexible and the model is static, so intertemporal issues play no role. There are three important elements in the model: (i) fixed adjustment costs for investment, which create an inaction zone; (ii) noisy idiosyncratic information about the aggregate economy; and (iii) imperfect substitution among private goods and goods provided by the government. An increase in government spending raises demand for private goods and may prevent a coordination failure. The optimal level of government expenditure is high when the desired level of investment is low, which we interpret as a time of low economic activity.JEL codes: E32, E62

Macroeconomic Effects of Government Spending: The Great Recession was (Really) Different

“…First, during the Great Recession a rise in public expenditures significantly reduced the spread between corporate and government bond yield supporting the financial accelerator mechanism as pointed out by Canzoneri et al (2016). Second, we find that a positive government spending innovation has increased consumer sentiment during that episode, a result that supports the confidence channel of fiscal policy recently suggested by Bachmann and Sims (2012), Beetsma et al (2015), and Guimaraes, Machado, and Ribeiro (2016). Indeed, our evidence suggests that future work should elaborate more on financial frictions and changes in confidence when studying fiscal policy interventions.…”

“…Guimares et al. () study the confidence channel in a theoretical framework. In their model equilibrium, the private sector fails to achieve the optimal level of aggregate demand.…”

“…Finally, the inclusion of an indicator of consumer confidence, cc t , follows the argument by Bachmann and Sims (2012), who find that confidence is an important determinant of the way in which fiscal policy innovations affect aggregate economic activity. Moreover, also Guimaraes, Machado, and Ribeiro (2016) and Beetsma et al (2015) argue in favor of the existence of a separate "confidence channel" of fiscal policy. We will discuss the potential role of this channel in affecting the response of private consumption to government spending shocks below in Section 3.…”

“…This, in turn, would stimulate economic activity because active fiscal policy preserved the economy from an even larger contraction. The confidence channel of fiscal policy has recently been empirically explored by Bachmann and Sims (2012) and Beetsma et al (2015), and a theoretical model highlighting this channel has been proposed by Guimaraes, Machado, and Ribeiro (2016). More generally, Barsky and Sims (2012) show that confidence innovations are associated with sizeable consumption and income growth.…”

The Impact of Deflation on Fiscal Aggregates

“…In the United States, regarding the Federal Reserve two political mistakes have been made. First, the initial collapse of prices and demand was considered "necessary" to correct the excess of the 1920s [Guimaraes, Machado and Ribeiro, 2016]. The collapse was seen as a result of non-monetary forces -including the creation of surplus capacity in the late 1920s -and beyond the influence of monetary policy.…”