Question

The standard RBC model predicts that a positive shock to government spending adversely affects private consumption spending. Provide two different changes to the standard RBC model that would generate a positive relationship between C and G. You don’t have to solve the model again to answer this question. Just focus on the intuition and the mechanisms that would generate the result. (10 points)

Answer 1

The real business cycle model assumes longrun structural changes in the economy and neglects in the inefficiency of the monetary and fiscal policies to bring about desired changes in the economy.The theory depends upon endogenous factors and optimal behaviour of the firms and individuals.

The two deviations that would bring a positive relationship between government spending and consumption spending is the analysis of the economic variables in the short run and the realisation of the endogeneous factors that bring about the changes in the economy.

The short term changes are more predictable compared to the long tem changes which would bring in fluctuations in the behaviour of the variables. Assuming there is still relevence in monetary policy and fiscal policy and a significant role of government intervention unlike what is assumed in RBC, there exists a positive reltionship between government expenditure and private final consumption expnditure.Becuase an increase in government spending generates both income and employment to different classes of people which would positively bring about a change in the consuption level of the economy.

Therefore an assuption of working of the model in the short run, and role of government intervention through fiscal policy can bring in a positive correlation between government spending and private consumption.