Estimation of an empirical FAVAR model and DSGE model for evaluating effects of government spending in Japan

This paper studies the effects of government spending on the economy through estimation of an empirical Factor Augmented Vector Autoregression (FAVAR) model and a theoretical DSGE model. We first conducted FAVAR using data for 107 time series from Japan, and found that an increase in government investment and consumption leads to an increase in private consumption and real wages. We then constructed a New Keynesian (NK) general equilibrium model with real and nominal rigidities, including Edgeworth complementarity/substitutability between private and government consumption and productive public capital. The model extends the Bouakez and Rebei (2007) model in three dimensions: constructing an NK model, including intertemporal investment adjustment cost and variable capital utilization as real rigidities, and introducing public capital stocks as an externality to the production function of intermediate goods firms. Our model succeeds in explaining private consumption and real wages increase in response to government expenditure shocks. We estimate key parameters of the model using Bayesian inference and show that private and government consumption are Edgeworth complements and marginal productivity of public capital is productive in Japan.