Does Government Spending Crowd in Private Consumption? Theory and Empirical Evidence for the Euro Area*

In this paper, we revisit the effects of government spending shocks on private consumption which have been at centre stage of the macroeconomic policy debate for quite a long time. We conduct our analysis in an estimated model of the euro area, which is representative of a new generation of dynamic stochastic general equilibrium (DSGE) models usable for quantitative policy analysis. We show that the inclusion of non‐Ricardian households, which simply consume their current disposable income, is in general conducive to raising the level of consumption in response to government spending shocks when compared with a benchmark specification without non‐Ricardian households. However, we find that there is only a fairly small chance that government spending shocks crowd in consumption, mainly because the estimated share of non‐Ricardian households is relatively low, but also because of the large negative wealth effect induced by the highly persistent nature of government spending shocks.