Abstract:
Empirical evidence on the effect of defense spending on US output is at best mixed. Against this backdrop, this paper
assesses the impact of a positive defense spending shock on the growth rate of real GNP using a Factor Augmented
Vector Autoregressive (FAVAR) model estimated with 116 variables spanning the quarterly period of 1976:01 to
2005:02. Overall, the results show that a positive shock to the growth rate of the real defense spending translates to a
positive short-run effect on the growth rate of real GNP lasting up to ten quarters, but the effect is significant only for
two quarters. Beyond the tenth quarter, the effect becomes negative and shows signs of slow reversal at around the
17th quarter. Our results tend to indicate that the mixed empirical evidence, based on small-scale Vector Autoregressive
(VAR) and Vector Error Correction (VEC) models, could be a result of a small information set not capturing the
true theoretical relationships between the two variables of interest.
