The Effects of Government Spending Shocks on Consumption under Optimal Stabilization

Economic theory has yet to come up with a general guidance regarding the dynamic effects and welfare implications of shocks to public spending. With the aim to provide a theoretical benchmark, we analyze if a rise in private consumption following an exogenous rise in government spending is a feature of the economy under optimal stabilization in a standard New Keynesian setting augmented for the presence of liquidityconstrained agents and non-separable preferences. Our results provide little evidence in support of a crowding-in effect under ‘timelessly optimal?policy.