THE EFFECTS OF A GOVERNMENT CONSUMPTION SHOCK

attention than the behavior of prices. The behavior of consumption, although, consistent with the Keynesian multiplier theory, stands in stark contrast with the prediction of the standard real business cycle (RBC) model. That is because in the standard RBC model an increase in government consump- tion raises the present value of the stream of taxes over time which generates a negative wealth effect that brings down private consumption. This prediction of the RBC model is described in Christiano and Eichenbaum (1992) and Baxter and King (1993), among others. The behavior of prices is even more difficult to explain since with the shock, aggregate demand increases more than aggregate supply. This pushes up prices. A few explanations have been proposed for the behavior of private consumption but none for the be- havior of the prices. To explain the behavior of consumption researchers were led to search for fea- tures that could be introduced in the standard RBC model in order to account for the empirical finding that private consumption responds positively to fiscal spending shocks. The few existing explanations are very intricate. Rather than using a complex model, full of frictions, to explain the apparent puzzles what we propose in this paper is a simple RBC model without capital but with three added features. All these features are empirically relevant. First, we give money a role in transactions by introducing cash-in-advance constraints for the agents, as in Lucas and Stockey (1987). Second, we assume that monetary policy has a liquidity effect like in Fuerst (1992) and Lucas (1990). Third, we suppose that the monetary authority reacts to government consumption innovations. The first modification places the interest rate in the consumption-leisure margin. This gives the mone- tary policy additional power to influence the economy. The second assumption makes the monetary policy non-neutral. As agents choose their portfolio of assets in advance, unexpected changes in the money supply change the interest rate. The third assumption allows the monetary policy to react to shocks in the economy, in particular to government consumption shocks. Theory shows that monetary policy improves economic performance if it is used to respond to shocks. It has been thought that there cannot be a positive response in private consumption to government consumption shocks as long as monetary policy is conducted in a reasonable manner. The common wisdom has been that the reasonable monetary policy will amplify the private consumption response. The government shock will create inflationary pressures and the anti-inflationary central bank will in- crease the interest rate in order to control inflation expectations. Thus, in that way it will decrease fur- ther the private consumption. To obtain the reverse result it would be necessary that the monetary