How does an increase in government purchases affect the economy?

Introduction and summary A classic question facing macroeconomists is: How does an increase in government purchases affect the economy? Our interest in this question is motivated by the desire to evaluate the properties of different rules and institutions for setting fiscal policy. For example, should government purchases vary systematically over the business cycle? What would the macroeconomic consequences of a balanced budget amendment be? What would the effect of a permanent decline in defense purchases be on aggregate employment and real wages? If we had observations on otherwise identical economies operating under the different fiscal policies that we are interested in evaluating , it would be easy to answer these types of questions. But we do not. So we have no choice but to attack them within the confines of economic models. Which model should we use? We have at our disposal a plethora of competing business cycle models, each of which incorporates different views of the way the economy functions and makes different recommendations for macroeconomic policy. So one’s views about the costs and benefits of different policy proposals depends critically on the model being used to assess the proposal. In this sense, research aimed at assessing the empirical plausibility of competing models is a crucial input to the policy process. One approach for choosing among competing models is to compare their predictions for the consequences of a shock for which we know how the actual economy responds.