Measuring the Effect of Government Spending Shocks on Output: A Factor-Augmented VAR Approach

Using a factor-augmented vector auto-regression model and quarterly U.S. data from 1960 to 2019, I estimate the effect of changes in government spending on key economic variables such as output and household consumption. Unlike previous studies which show a positive effect of government spending on output, I find that adding factors to the VAR model erases the positive effect of spending and reveals a small but statistically significant negative response in output and consumption. Other instances of crowding out include increases in interest rates and price levels and decreases in investment and net exports.