National security, military spending and the business cycle

Abstract

This paper develops a Dynamic Stochastic General Equilibrium model where national security is an argument in the agent’s utility function and the government chooses optimally the level of military spending to maximize social welfare. National defense depends on military expenditure and on the strategic environment reflecting a potential hostile external threat. We use aggregate data on consumption, investment, and military spending for the US economy to estimate the parameters of the model. Estimation results suggest that consumption and national defense are complements and that military spending variability is mainly explained by external threat shocks although it also depends on the macroeconomic conditions. We compute impulse response functions of the main macroeconomic variables to several shocks: a total factor productivity shock, a defense technology shock, and a strategic environment shock. Surprisingly, we find that the optimal response to an increase in the external threat (a worsening in the strategic environment) will rise output by reducing consumption and increasing investment.