Revisiting the Supply-Side Effects of Government Spending

Abstract

We revisit the macroeconomic effects of government consumption in the neoclassical growth model when agents face uninsured idiosyncratic investment risk. Under complete markets, a permanent increase in government consumption has no long-run effect on interest rates and capital intensity, while it increases work hours due to the negative wealth effect. These results are upset once we allow for incomplete markets. The same negative wealth effect now causes a reduction in risk taking and the demand for investment. This leads to a lower risk-free rate and, under certain conditions, also to a lower capital–labor ratio and lower productivity.