On Modeling the Effects of Government Policies

An important question in macroeconomics is how government policies affect the cconomy. The fact that this question is still being debated forty-three years after John Maynard Keynes wrote The General Theory and thirty-nine years after Jan Tinbergen did his pioneering econometric study of business cycles for the League of Nations indicates the difficulty of answering it. Although it is easy to construct theoretical models in which government policies do or do not have important effects on, say, real output, it is difficult to test alternative models. One difficulty is the relative ease with which aggregate timeseries data can be fit well within the sample period. Because of this, a good within-sample fit is by no means a guarantee that the particular equation or model is a good representation of the actual process generating the data. It is also dificult to make comparisons of predictive accuracy across models because of dill&aces in the number and types of variables that are taken to be exogenous. These difficulties are annoying and have undoubtedly contributed to giving macroeconomics a bad name. The purpose of this paper is to review that part of my recent work that relates to modeling the effects of government policies. In my econometric model, government actions, even if they are anticipated, can have important effects on real output, and in Section 1 the theoretical basis for this property is reviewed. In Section II the sensitivity of policy effects in the model to a number of alternative assumptions is examined. These assumptions concern 1) the behavior of the Federal Reserve, 2) whether or not there are rational expectations in the bond and stock markets, and 3) whether or not government bonds are treated as wealth by the household sector. In Section