Uncertainty and Effectiveness of Public Consumption

Abstract

This article investigates how increased uncertainty affects the effectiveness of public consumption on economic activity. The paper examines three main issues: first, the influence of uncertainty on output and macroeconomic aggregates. Second, the effects of public consumption on the economy. Third, the impact of a simultaneous shock of uncertainty and government consumption on economic activity.We use Vector Autoregression (VAR) models for the United States, Brazil and a panel VAR with six European countries. The empirical results indicate a disruptive effect of uncertainty on GDP, private consumption, investment and hours worked. The fiscal effects point to slightly different results for the two countries. For Brazil and the United States, the increase in public spending has positive and significant effects on GDP. Regarding the effects of government consumption (high uncertainty), the fiscal effects are not statistically significant, while in times of low uncertainty the effects are positive and significant.Subsequently, we designed a Dynamic Stochastic General Equilibrium (DSGE) model akin to Basu and Bundick (2017), and added three features: tax on labor income, the relationship between private consumption and government consumption and a simultaneous shock of uncertainty and government consumption. The model highlights four main conclusions. First, the negative influence of uncertainty on economic activity. Second, risk aversion magnifies the impact of the macroeconomic response. Third, public consumption has positive effects on economic activity. Finally, we examine the sensitivity of the economy's responses to different configurations of the relationship between public and private consumption, under normal conditions or uncertainty shocks. The findings suggest that, when the economy is hit by a simultaneous shock of uncertainty and public consumption, it obscures the effectiveness of the fiscal stimulus on the economy, corroborating the empirical results.