Temporary and permanent government spending in an open economy: Some evidence for the United Kingdom

Abstract

This paper investigates the effects of government spending changes on a small open economy in an intertemporal substitution framework. If agents internalize the government's budget constraint, temporary and permanent spending have different implications for wealth and consequently different effects on output and the balance of trade. Estimation of these effects isolates the different channels through which government spending can influence economic activity. Main findings for the United Kingdom are that government spending (i) crowds out private spending, (ii) is directly productive, and (iii), when rising permanently, leads to a negative wealth effect which induces a large rise in work effort.