Confidence and the transmission of government spending shocks

Is impacting confidence an important channel by which government spending shocks affect economic activity? In a standard structural VAR, an empirical measure of confidence does not significantly react to spending shocks and output multipliers are around one. In a non-linear VAR, confidence rises following an increase in spending during periods of economic slack and multipliers are much larger. The systematic response of confidence is irrelevant for the output multiplier during normal times, but is critical during recessions. Spending shocks during downturns predict productivity improvements through a persistent increase in government investment relative to consumption, which is reflected in higher confidence.

► Examine role of systematic response of confidence in transmission of fiscal shocks. ► In normal times government spending multiplier near one and confidence unimportant. ► In times of slack multiplier much larger and confidence seems to matter. ► Spending shocks in downturn more geared to government investment than consumption. ► Higher government investment stimulates productivity, output, and confidence.