Adjustment Dynamics in the Euro Area — A Fresh Look at the Role of Fiscal Policy. Using a DSGE Approach

Dynamic stochastic general equilibrium (DSGE) models typically (as do most models) treat government spending as wasteful; such spending does not contribute to enhancing private sector utility or productivity. Some researchers have recently introduced productive government investment spending into DSGE models, which has a longer theoretical history, adding a supply channel. This paper takes a similar perspective but it also introduces the government consumption good into the household utility function and this consumption good is supplied by a government production function. While higher government investment can increase private output and household consumption in the future, in the short run household utility is likely to decline because current consumption of private and government goods is
shifted into investment. At the same time even though the government consumption good enhances household utility, increased production would shift labor from the private sector to the public sector, reducing the supply of privately produced consumption goods. This adds another supply channel to the usual aggregate demand effects. Although these considerations are generally applicable, they have greater import for Euro-area members because fiscal
policy is the only national macroeconomic policy tool.