The Adverse Eects of Government Spending in New Keynesian Models

Empirical evidence shows that government spending crowds in private consumption, a Keynesian phenomenon. The current state of the art, New Keynesian models based on optimising households and rms, is not able to predict such a result. We show with a graphical framework as well as a formal model why the basic New Keynesian model fails at this. We also show the weaknesses of extensions aimed at generating crowding in like useful government spending or rule of thumb consumers. Finally, we argue that introducing productivity enhancing government spending could potentially lead to crowding in.

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