National security, military spending and the business cycle

Abstract

This paper develops a Dynamic Stochastic General Equilibrium model where national security is an argument in the agent’s utility function and the government chooses optimally the level of military spending to maximize social welfare. National defense depends on military expenditure and on the strategic environment reflecting a potential hostile external threat. We use aggregate data on consumption, investment, and military spending for the US economy to estimate the parameters of the model. Estimation results suggest that consumption and national defense are complements and that military spending variability is mainly explained by external threat shocks although it also depends on the macroeconomic conditions. We compute impulse response functions of the main macroeconomic variables to several shocks: a total factor productivity shock, a defense technology shock, and a strategic environment shock. Surprisingly, we find that the optimal response to an increase in the external threat (a worsening in the strategic environment) will rise output by reducing consumption and increasing investment.

Keywords:

• Hostile external threat
• National security
• Military spending
• Dynamic Stochastic General Equilibrium models

JEL Codes:

• E20
• H41
• H56

Acknowledgments

We thank A. Bongers, N. Cámara, J. Rodríguez, J.J. Pérez and an anonymous referee for very useful comments and suggestions on earlier versions of the paper.

Notes

¹ Surveys of the literature are, for instance, Sandler and Hartley (1995) and Ram (1995).

² Alternatively, we can assume a market environment, where agents take decisions on consumption and investment and the government decides the level of military expenditures, financed with non-distortionary taxation, taking into account the agents preferences. Given that the objective function of the central planner is to maximize social welfare, both situations are equivalent.

³ Leisure is not considered as an additional argument of the utility function. Instead, labor is assumed to be inelastically supplied and therefore constant. A version of the model with leisure in the utility function delivers similar results.

⁴ See Sandler and Hartley (1995) for a survey of this literature. Others surveys are, for instance, Deger and Sen (1995), Gleditsch et al. (1996) and Ram (1995).

⁵ Aizenman and Glick (2006) use a proxy for the external threat the number of years a country was at war with each of its adversaries during a period summed over the set of its adversaries.

⁶ Ward (1984) finds that United States reduces its defense spending when the level of international tension decreases.