There seems to be a widespread belief among economists, policy-makers, and members of the media that the "confidence'" of households and businesses is a critical component in the transmission of fiscal policy shocks into economic activity. We take this proposition to the data using standard structural VARs with government spending and aggregate output augmented to include empirical measures of consumer or business confidence. We also estimate non-linear VAR specifications to allow for differential impacts of government spending in "normal'' times versus recessions. In normal times confidence does not react significantly to unexpected increases in government spending and spending multipliers are in the neighborhood of one; during recessions confidence rises and spending multipliers are significantly larger. We then quantify the importance of the systematic response of confidence to spending shocks for the spending multiplier and find that, in normal times, confidence is irrelevant for the transmission of government spending shocks to output, but during periods of economic slack it is important. We argue and present evidence that it is not confidence per se -in the sense of pure sentiment -that matters for the transmission of spending shocks during downturns, but rather that the composition of spending during a downtown is different. In particular, spending shocks during downturns predict future productivity improvements through a persistent increase in government investment relative to consumption, which is in turn reflected in higher measured confidence.
There seems to be a widespread belief among economists, policy-makers, and members of the media that the "confidence" of households and firms is a critical component of the transmission of fiscal policy shocks into economic activity. In this paper we take this proposition to the data. We use standard restrictions from the literature to identify government spending shocks in VARs augmented to include empirical measures of consumer or business confidence. We also estimate non-linear specifications to allow for differential impacts of government spending in normal times versus recessions. Our first result is that in normal times confidence does not react significantly in response to unexpected increases in government spending; during recessions it rises. In addition, the spending multiplier is much larger in recessions than in normal times. We then construct counterfactual impulse responses in which the response of confidence to government spending shocks is "shut down". Comparing the actual and counterfactual responses of output allows us to determine the importance of confidence as a transmission mechanism of policy. We find as our second result that confidence is irrelevant in the transmission of government spending shocks to output in normal times, but is very important during downturns. Third, we provide some evidence that this is because spending shocks during downturns predict future productivity rises through persistent increases in government investment relative to government consumption.
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