Understanding the Effects of Government Spending on Consumption

Recent evidence suggests that consumption rises in response to an increase in government spending. That finding cannot be asily reconciled with existing optimizing business cycle models. We extend the standard new Keynesian model to allow for the presence of rule-of-thumb consumers. We show how the interaction of the latter with sticky prices and deficit financing can account for the existing evidence on the effects of government spending. (JEL: E32, E62) (c) 2007 by the European Economic Association.