Government Spending Shocks and Private Activity: The Role of Sentiments

This paper studies the dynamic effects of the fiscal policy shock on private activity using an array of vector autoregressive models for the post-war US data. We are particularly interested in the role of consumer sentiment in the transmission of the government spending shock. Our major findings are as follows. Private consumption and investment fail to rise persistently in response to positive spending shocks especially when shocks are anticipated, while they exhibit persistent and significant increases when the sentiment shock occurs. Employment and real wages in the private sector also respond significantly positively only to the sentiment shock. Consumer sentiment responds negatively to a positive fiscal shock, resulting in subsequent decreases in private activity. That is, our empirical findings imply that the government spending shock generates consumer pessimism, which then weakens the effectiveness of the fiscal policy. We further strengthen our claims via counterfactual simulation exercises.