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Unformatted text preview: Federal Reserve Bank of Minneapolis Research Department Staff Report 315 Revised November 2008 Does Neoclassical Theory Account for the Effects of Big Fiscal Shocks? Evidence from World War II * Ellen R. McGrattan Federal Reserve Bank of Minneapolis and University of Minnesota Lee E. Ohanian University of California, Los Angeles and Federal Reserve Bank of Minneapolis ABSTRACT 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. 1. Introduction World War II is the largest fiscal shock in the history of the United States, and it also rep- resents the most significant economic boom in U.S. history. Many economists agree that wartime government spending contributed to this economic boom. But beyond this general level of agree- ment, there is significant debate about the impact of World War IIand more generically the impact of other large fiscal changeson the economy. A major point of disagreement is the ap- propriate theoretical framework for quantitatively studying the impact of World War II on the economy. Some economists argue that the standard neoclassical growth model is a useful tool for accounting for World War II, while others argue that accounting for the impact of such large fiscal changes requires major departures from the neoclassical framework. 1 The disagreement about the usefulness of the neoclassical model for understanding World War II partially reflects the fact that there is no comprehensive analysis of the impact of the World War II shock on the U.S. economy using the neoclassical model. Consequently, there are several open questions: What are the neoclassical models successes and failures in accounting for the World War II economy? What are the impacts of the other large World War II changes, such as the very large changes in tax rates, in government investment, and in the draft? World War II is the biggest macroeconomic shock to hit the U.S. economy and therefore provides a unique opportunity to test the neoclassical model....
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- Fall '08