Defense spending and asset prices: The role of cointegration and high-dimensional macroeconomic data

This paper examines the impact of government spending shocks on stock and house prices using a Structural Dynamic Factor Model (SDFM) with cointegrated factors and a large dataset of 207 U.S. macroeconomic variables. While prior studies on SVARs report a negative effect of fiscal shocks on asset markets, we find that stock and house prices respond positively to expansionary government spending, particularly defense spending shocks. Our approach addresses the limitations of SVARs by capturing a broader set of macroeconomic dynamics and preserving long-term relationships among variables. The results highlight that fiscal policy can stimulate asset markets through increased income, lower interest rates, and stronger investor confidence, which is consistent with Keynesian channels. These findings challenge prevailing evidence and underscore the importance of high-dimensional, data-rich frameworks in macroeconomic and financial analysis. This paper offers new insights into the transmission mechanisms of fiscal policy and its relevance for market-based policy evaluation.