Imperfect information and the excess sensitivity of private consumption to government expenditures

In this paper we consider a new explanation for the often encountered observation that private consumption is excessively sensitive to anticipated government expenditures. We show that this excess sensitivity arises if consumers are aware of the government’s intertemporal budget constraint, but lack exact information on the aggregate economy. Given the strong assumption that consumers incorporate the government budget constraint, we test our model in three high debt countries where it is more likely that consumers have developed an awareness for government issues. In some of these countries and especially during periods of high debt accumulation, we observe some excess sensitivity with respect to (lagged) income and government expenditures which can be interpreted as evidence supporting our model.