Are Government Stimulus Packages Really that Harmful? An Analysis of the Underlying Information Structure

Abstract

The following paper analyzes the consequences of a government intervention in an economic environment where the households are unable to observe all economic shocks of interest. As it was recently presented in the literature, a government intervention that is designed to stabilize such an economy may actually be harmful. This effect is rooted in the households’ information set. Whenever the households are able to observe the government’s behavior, they may get additional information about the state of the economy and revise their decisions. This in turn, may lead to a more awkward equilibrium and thereby hurt the economy. However, this effect has, by now, only been highlighted in an economy without capital and a tight connection to the empirical literature. To fill this gap, we employ a New Keynesian model and allow for heterogeneous expectations. Our results suggest that a closer consideration of the empirical observations changes the results substantially. In particular, it is advisable to model the households’ heterogeneity more carefully, since it appears to be a major driver of recent results.