Costly Capital Reallocation and the Effects of Government Spending

Changes in government spending often lead to significant shifts in demand across sectors. This paper analyzes the effects of sector-specific changes in government spending in a two-sector, dynamic general equilibrium model in which the reallocation of capital across sectors is costly. The two-sector model leads to a richer array of possible responses of aggregate variables than the one-sector model. The empirical part of the paper estimates the effects of military buildups on a variety of macroeconomic variables using a new measure of military shocks. The behavior of macroeconomic aggregates is consistent with the predictions of a multisector neoclassical model.