The Output and Welfare Effects of Fiscal Shocks over the Business Cycle∗

How does the magnitude of the output response to a change in government spending vary over the business cycle? What are the welfare effects of fiscal shocks? This paper studies the state-dependence of the output and welfare effects of shocks to government purchases in a DSGE model with a number of real and nominal frictions and a rich fiscal financing structure. Both the output multiplier (the change in output for a one dollar change in government spending) and the welfare multiplier (the consumption equivalent change in welfare for the same change in spending) move significantly across states, though movements in the welfare multiplier are quantitatively much larger than for the output multiplier. The output multiplier is high in bad states of the world resulting from negative “supply” shocks and low when bad states result from “demand” shocks. The welfare multiplier displays the opposite pattern – it tends to be high in demand-driven recessions and low in supply-driven downturns. In an historical simulation based on estimation of the model parameters, the output multiplier is found to be countercyclical and strongly negatively correlated with the welfare multiplier. JEL Codes: E30, E60, E62