4 Non-technical summary 5 Conclusions 32 References 34 Appendices 38 Tables and fi gures 45 CONTENTS Abstract This paper provides new evidence on the effects of government spending shocks and the fiscal transmission mechanism in the euro area for the period 1980-2008. Our contribution is two-fold. First, we investigate changes in the macroeconomic impact of government spending shocks using time-varying structural VAR techniques. The results show that the short-run effectiveness of government

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... nding in stabilizing real GDP and private consumption has increased until the end-1980s but it has decreased thereafter. Moreover, government spending multipliers at longer horizons have declined substantially over the sample period. We also observe a weaker response of real wages and a stronger response of the nominal interest rate to spending shocks. Second, we provide econometric evidence on the driving forces behind the observed time variation of spending multipliers. We find that a higher ratio of credit to households over GDP, a smaller share of government investment and a larger share of public wages over total government spending have led to decreasing contemporaneous multipliers. At the same time, our results indicate that higher government debt-to-GDP ratios have negatively affected long-term multipliers. sponse of real wages, whereas the short-term nominal interest rate shows a stronger reaction to spending shocks. With respect to the factors behind the observed time evolution of government spending multipliers, our evidence indicates that better access of households to credit reduces the short-term effectiveness of expenditure based fiscal stimuli. This suggests that the presence of credit constraints and limited asset market participation limits Ricardian behaviour since a larger share of agents cannot borrow or save immediately against a higher future tax burden. In addition, we find that the composition of government spending matters. In particular, a lower share of government investment and a larger wage component in total spending may have contributed to the documented decline in short-term multipliers. These findings support the argument that government investment may have an additional positive aggregate supply effect in addition to the aggregate demand effect through government goods purchases. Finally, our results indicate that rising government debt is the main reason for declining spending multipliers at longer horizons, and thus increasingly negative long-run consequences of fiscal expansions. In the spirit of Giavazzi and Pagano (1990) and Giavazzi, Jappelli, and Pagano (2000) , we interpret this finding as an indication that further accumulating debt after a spending shock leads to rising concerns on the sustainability of public finances. In this context, agents may expect larger fiscal consolidation in the future which, in turn, depresses private demand and output.