Fiscal shocks and their consequences

This paper investigates the response of hours worked and real wages to fiscal policy shocks in the U.S. during the post World War II era. We identify these shocks with exogenous changes in military purchases and argue that they lead to a persistent increase in government purchases and tax rates on capital and labor income, and a persistent rise in aggregate hours worked as well as declines in real wages. The shocks are also associated with short lived rises in aggregate investment and small movements in private consumption. We describe and implement a methodology for assessing whether standard neoclassical models can account for the consequences of a fiscal policy shock. Simple versions of the neoclassical model can account for the qualitative effects of a fiscal shock. Once we allow for habit formation and investment adjustment costs, the model can also account reasonably well for the quantitative effects of a fiscal shock. ∗This paper is a substantial revision to “Assessing the Effects of Fiscal Shocks” which appeared as NBER working paper no. 7459. We would like to thank Lawrence J. Christiano and Lars Hansen for helpful conversations. In addition we would like to thank several referees for useful comments. The views expressed in this paper do not necessarily represent the views of the Federal Reserve Bank of Chicago, the Federal Reserve System or the World Bank. Martin Eichenbaum gratefully acknowledges the financial support of a grant from the National Science Foundation to the National Bureau of Economic Research. Craig Burnside gratefully acknowledges the support of a National Fellowship from the Hoover Institution. †University of Virginia ‡ Northwestern University, Federal Reserve Bank of Chicago, NBER §Federal Reserve Bank of Chicago