Does Neoclassical Theory Account for the Effects of Big Fiscal Shocks? Evidence from World War II

There is much debate about the usefulness of the neoclassical growth model for assessing the macroeconomic impact of fiscal shocks. We test the theory using data from World War II, which is by far the largest fiscal shock in the history of the United States. We take observed changes in fiscal policy during the war as inputs into a parameterized, dynamic general equilibrium model and compare the values of all variables in the model to the actual values of these variables in the data. Our main finding is that the theory quantitatively accounts for macroeconomic activity during this big fiscal shock. ∗We thank the National Science Foundation for financial support. We also thank Casey Mulligan, Cristina DeNardi, Ed Prescott, Julio Rotemberg, and three referees for helpful comments on earlier drafts. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.