DP15894 The Transmission Channels of Government Spending Uncertainty

Author(s): Beliansk Anna, Aurélien Eyquem, Céline Poilly
Publication Date: March 2021
Keyword(s): Government spending uncertainty, portfolio adjustment cost, stochastic volatility
JEL(s): E52, E62
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=15894

Higher uncertainty about government spending generates a persistent decline in the economic activity in the Euro Area. This paper emphasizes the transmission channels explaining this empirical fact. First, a Stochastic Volatility model is estimated on European government consumption to build a measure of government spending uncertainty. Plugging this measure into a SVAR model, we stress that government spending uncertainty shocks have recessionary, persistent and humped-shaped effects. Second, we develop a New Keynesian model with financial frictions applying to a portfolio of equity and long-term government bonds. We argue that a portfolio effect -- resulting from the imperfect substitutability among both assets -- acts as a critical amplifier of the usual transmission channels.