DP9948 Chronicle of a War Foretold: The Macroeconomic Effects of Anticipated Defense Spending Shocks

Author(s): Nadav Ben Zeev, Evi Pappa
Publication Date: April 2014
Keyword(s): defense spending news, DSGE model, maximum forecast error variance, SVAR
JEL(s): E62, E65, H30
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=9948

We identify US defense news shocks as shocks that best explain future movements in defense spending over a five-year horizon and are orthogonal to current defense spending. Our identified shocks are strongly correlated with the Ramey (2011) news shocks, but explain a larger share of macroeconomic fluctuations and have significant demand effects. Fiscal news induces significant and persistent increases in output, consumption, investment, hours and the interest rate. Standard DSGE models fail to produce such a pattern. We propose a sticky price model with distortionary taxation, variable capital utilization, capital adjustment costs and rule-of-thumb consumers that replicates the empirical findings.