The Effects of Government Spending on Non-Traded Goods

Abstract

It is widely believed that fluctuations in government spending influence economic variables such as output, consumption, investment, and real interest rates. Recent business cycle models have reemphasized that government purchases have a substantial business cycle role. Works of Barro [8] and Hall [15] have inspired a great deal of research in identifying and quantifying the effects of government purchases during business cycle episodes. This paper pursues this line of research. In particular, it studies theoretically and empirically the role of government purchases in the cyclical behavior of the relative price of non-traded goods in terms of traded goods and output of non-traded goods in a two-country world. Following Barro [8], it emphasizes the distinction between temporary and permanent government spending since these two components have different implications for wealth and consequently have different effects on the economy. This paper illustrates that temporary foreign government spending reduces the home relative price of non-traded goods and output of home non-traded goods. Temporary home government spending raises output of home non-traded goods. The effects of home temporary government spending on the home relative price of non-traded goods are, in general, ambiguous. The empirical implementation of the model employs Canadian and U.S. quarterly data for the period 1968:1-1987:111.' We treat Canada as the home country and the U.S. as the foreign country and estimate the model by nonlinear least squares. The results indicate that temporary U.S. government spending reduces the Canadian relative price of non-traded goods and output of non-traded goods. The results also suggest that temporary Canadian government spending raises output of Canadian non-traded goods and reduces the Canadian relative price of non-traded