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Nonseparable preferences, fiscal policy puzzles, and inferior goods.

Article Excerpt
THIS PAPER STUDIES purely preference-based explanations of some recent puzzles pertaining to the effects of fiscal policy shocks. The puzzles concern the positive response of private consumption to government spending (and the associated positive co-movement between consumption and hours worked) found by Blanchard and Perotti (2003), Fatas and Mihov (2001), and Gali, Lopez-Salido and Valles (2007) for U.S. data and by Perotti (2005) for OECD countries. Standard, frictionless business cycle models using separable preferences over consumption and leisure cannot generate either of these observations since they imply that taxation used to finance the spending has a negative wealth effect that translates into an increase in hours worked and a fall in consumption (e.g., Baxter and King 1993).

In a recent paper, Linnemann (2006) argues that these puzzles can be solved in a frictionless business cycles model if one considers a certain type of nonseparability over consumption and leisure in the utility function. A first undesirable feature of the preferences considered by Linnemann is that they rely on a downward-sloping constant-consumption labor supply schedule. I first generalize this result: considering fully general nonseparable preferences, I find conditions on preferences under which the puzzles are resolved, without the need for assuming a negative constant-consumption labor supply elasticity, in a model in which these conditions can be found analytically.

However, I further show that the conditions under which (fully general) nonseparable preferences generate an increase in private consumption in response to government spending are satisfied if and only if the consumption good is inferior (non-normal). (1) Moreover, the positive co-movement between consumption and hours occurs if and only if either consumption or leisure is inferior. This result is intuitive: ah increase in government spending financed by lump-sum taxation generates a fall in income; ir consumption is to increase (in the absence of agent heterogeneity and/or demand effects), it must mean that the consumption good is inferior (its demand increases when income falls, i.e., its demand falls when income increases). When leisure is inferior and consumption is not, both consumption and hours fall when government spending increases.

The "puzzles' resolution" based on nonseparable preferences may at first sight seem preferable based on simplicity grounds; indeed, Occam's razor implies in this context that among theories competing to explain a given set of facts, one should prefer the one that uses the minimal set of unproven assumptions. The results of this paper imply that alternative theories purported to explain these puzzles by using more complicated models would in fact be preferable insofar as they do not rely on the consumption good being inferior. More generally, this paper implies that the use of nonseparable preferences should be taken with care.

1. NONSEPARABLE PREFERENCES AND A POSSIBLE RESOLUTION OF THE PUZZLE(S)

Suppose that the representative...

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