LIQUIDITY CONSTRAINTS AND THE SUBSTITUTABILITY BETWEEN PRIVATE AND GOVERNMENT CONSUMPTION: THE ROLE OF MILITARY AND NON‐MILITARY SPENDING

I. INTRODUCTION Using data for a number of economies, we investigate (i) the relationship between private consumption and two types of government spending (military and non-military), and (ii) the severity of liquidity constraints. Because of their importance for macroeconomic modeling in theory and practice,(1) both issues have been the subjects of considerable theoretical and empirical investigation. On the issue of liquidity constraints, the most influential research has relied on Hall's [1978] Euler-equation approach to the Permanent Income Hypothesis. In an attempt to reconcile Hall's and Flavin's [1981] methodologies, Hayashi [1982] modified Hall's martingale result to allow for the possibility that a subset of consumers are liquidity constrained, and showed that liquidity constraints can result in consumption's "excess sensitivity" to current income. Campbell and Mankiw [1989; 1990; 1991] and Jappelli and Pagano [1989] have applied Hayashi's methodology using data from the U.S. and several other OECD countries. On the substitutability issue, Aschauer [1985] has modified Hall's Euler equation to allow for substitutability between government spending and private consumption, and found that the two are substitutes for the U.S. Karras [1994], however, using a similar approach and data for 30 countries concludes that private and government consumption are better described as complementary or unrelated. Liquidity constraints and substitutability have been combined in studies by Graham and Himarios [1991], Cushing [1992], and Graham [1993], using U.S data, and by Evans and Karras [1996] for a number of countries. A crucial limitation of most of these studies is the use of aggregate government consumption data, which counterintuitively imposes a common substitutability parameter on all components of government spending.(2) Using recently available time-series data for a large number of countries, the present paper relaxes this restriction by decomposing government consumption into military and non-military components, enabling us to separately identify their relationship to private consumption. The allocation of government consumption between military and non-military functions has varied greatly across countries. The Appendix reports the average size of military and non-military government shares in GDP, as well as the military/non-military ratio by country over the 1970-1989 period. Average military expenditure as a fraction of GDP, for example, has ranged in our sample from 0.11% in Mexico to 12.30% in Jordan. Similarly, the fraction of government consumption absorbed by military expenditure has ranged from 1.09% in Mauritius to 66.82% in Poland. This sizable variability is promising in terms of cross-sectional identification power, but it also suggests that the estimated parameters must not be assumed to be common across countries. The estimated model is derived in Section II, which combines liquidity constraints and substitutability by nesting the approaches of Hayashi [1982] and Aschauer [1985]. In the same section we discuss data sources and the estimation strategy, which permits the estimated parameters to vary by country in a way that helps determine how they are influenced by country-specific factors. Section III estimates the model for a panel of the 66 countries for which annual data on all series are available for the 1970-1989 period. The paper's main conclusions are given in Section IV. II. METHODOLOGY AND DATA We assume that consumers in economy i at time t derive utility from effective consumption, [c.sup.*], which we define as (1) [Mathematical Expression Omitted], where c is private consumption, [g.sup.m] and [g.sup.nm] are the military and non-military components of government consumption. The parameters [[Theta].sup.m] and [[Theta].sup.nm] measure the degree of substitutability between c and [g.sup.m], and c and [g.sup.nm], respectively. …