CES - Discussion paper series, DPS13.09 pages:1-44
We find VAR evidence that a rise in US government spending boosts consumption and firm entry. The joint dynamics observed in the data poses a puzzle for business cycle models with endogenous entry (extensive-margin investment). Persistent spending expansions generate entry but crowd out consumption through a negative wealth effect. Model features that dampen the wealth effect, such as credit-constrained consumers or non-separable preferences, reduce entry. This leads to weaker competition in oligopolistic
markets, such that markups rise and consumption falls. The model captures the joint dynamics if labor supply is very elastic or public and private consumption are complements.