Government Employment and the Dynamic Effects of Fiscal Policy Shocks

Abstract

Since World War II, about 75 percent of government consumption in the U.S. economy has been spent on labor services. I distinguish the goods and the employment compensation components of government consumption in assessing the effects of fiscal shocks on main macroeconomic variables. Identifying exogenous fiscal shocks with the onset of military buildups, I show that they lead to a significant increase in hours worked and output in the government sector. Allowing for the distinction between the two components of government consumption improves the quantitative performance of the neoclassical model. In particular, the model with government employment does a good job at accounting for the dynamic response of private consumption to a fiscal policy shock. Government employment compensation acts as a transfer payment for households, thereby mitigating the wealth effect on consumption and labor supply associated with fiscal shocks.