On Modeling the Effects of Government Policies
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On Modeling the Effects of Government Policies By RAY C. FAIR* An important question in macroeconomics III the testing of the model is discussed. Two is how government policies affect the ccono- types of tests arc considered in this section: my. The fact that this question is still being tests of individual hypotheses and tests of the debated forty-three years after John May- accuracy of the overall model. The main nard Keynes wrote The General Theory and points of the paper are summarized in Section thirty-nine years after Jan Tinbergen did his 1v. 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 The proposition that government tax rates government policies do or do not have impor- and transfer payments affect the decisions of tant effects on, say, real output, it is difficult households and firms is familiar from micro- to test alternative models. One difficulty is economics. In the theoretical model upon the relative ease with which aggregate time- which my econometric model is based (see the series data can be fit well within the sample author, 1974, 1976), the “micro-economic” period. Because of this, a good within-sample aspect of individual decisions has been fit is by no means a guarantee that the stressed. The decisions of the individual particular equation or model is a good repre- agents in the model (households, firms, and sentation of the actual process generating the banks) are derived from the solutions of data. It is also dificult to make comparisons multiperiod optimization problems. At the of predictive accuracy across models because beginning of each period each agent solves its of dill&aces in the number and types of optimization problem, knowing all past variables that are taken to be exogenous. values, receiving in some cases information These difficulties are annoying and have from others regarding certain current-period undoubtedly contributed to giving macro- values, and forming expectations of future economics a bad name. values. A number of government policy vari- The purpose of this paper is to review that ables affect the solutions of these problems, part of my recent work that relates to model- and so through this channel government ing the effects of government policies. In my actions affect the economy. Tax rates and econometric model, government actions, even transfer payments, for example, affect the if they are anticipated, can have important labor-leisure choice of the utility-maximizing effects on real output, and in Section 1 the households. theoretical basis for this property is reviewed. Although these micro-economic effects are In Section II the sensitivity of policy effects in fairly well accepted in the profession, they do the model to a number of alternative assump- not exist in a popular class of rational expec- tions is examined. These assumptions concern tations macro models (see Robert J. Barre, 1) the behavior of the Federal Reserve, 2) Robert E. Lucas, Jr., Thomas J. Sargent, whether or not there are rational expectations 1973, 1976, and Sargent and Neil Wallace). in the bond and stock markets, and 3) Elsewhere (1978b), I have criticized this class whether or not government bonds are treated of models for postulating that individuals are as wealth by the household sector. In Section rational with respect to their expectation formation but not rational with respect to their overall behavior. This is an important ‘Cowks Foundation, department of economics, Yale criticism of these models in that their key University.The research dexrikd in this paper was financed by grant SOC77-03274 from the National property regarding the ineffectiveness of Science Foundation. anticipated government actions on real output 86 VOL. 69 NO. 2 THE EFFECTIVENESS OF FISCAL POLICY 87 no longer holds if rationality with respect to prices and wages may not always clear overall behavior is introduced into the models. markets. In my model, on the other hand, In a “completely” rational model the govern- such an explanation is provided, namely the ment can affect real output by affecting, possibility of expectation errors on the part of among other things, the labor-leisure choice firms. ln short, my model, unlike Barre and of households. Grossman’s, is “choice theoretic” with respect There is also in my theoretical model to the determination of prices and wages. another reason government actions can affect Because of this weakness of the Barro- the economy. The model allows for the exis- Grossman model, Grossman is now advocat- tence of disequilibrium, and if there is ing another theory of employment fluctua- disequilibrium, the government can, by tions, a theory in which market transactions conventional means, help to correct it. Dis- are viewed as involving implicit contractual equilibrium takes the form of banks arrangements for mitigating risk. constraining firms and households in how much money they can borrow at the current II. The Sensitivity of Policy EtTects loan rates and of firms constraining house- to Alternative Assumptions holds in how much they can work at the current wage rates. Binding constraints in the The properties of macro-econometric loan market are due to mistakes on the part of models tend to be sensitive to alternative banks in setting loan rates, and binding assumptions. Given the difficulty of testing constraints in the labor market are due to assumptions, this means that any policy mistakes on the part of firms in setting prices recommendations that result from analyzing and wages. These mistakes are the result of a model must be interpreted with consider- expectation errors. No agent knows the able caution. Some assumptions are, however, complete model, and so expectations can turn more important than others in this regard, out to be wrong even though there are no and the purpose of this section is to review the random shocks in the model. There is, howev- sensitivity results that 1 have obtained with er, a continual adjustment to past mistakes in my model. that each period the individual agents form Fiscal policy effects in the model are, as a new set of expectations and reoptimize on reported in my 1978a paper, quite sensitive to the basis of information from the previous assumptions about monetary policy. The period. results of five experiments are presented here. The key premise of my theoretical work is Each experiment corresponded to the same thus that agents each period first form a set of fiscal policy shock (an increase in government expectations of future values and then given purchases of goods). For four of the experi- these expectations base their decisions on the ments the behavior of the Fed was assumed to solutions of multiperiod optimization prob- be exogenous: in each of these cases the Fed lems. The expectations may be in error, and was assumed to control a particular variable, so banks and firms may set values of loan which was then taken to be exogenous for the rates, wages, and prices that are not market experiment. (By exogenous here is meant that clearing. Both the micro-economic and dis- for the experiment the variable was kept equilibrium aspects of this premise imply that unchanged each period from its base-simula- the government can affect real variables in tion value.) The control variables in the four the economy. cases were: 1) the amount of government One important difference between my securities outstanding; 2) the money supply; theoretical model and a disequilibrium model 3) nonborrowed reserves: and 4) the bill rate. like that of Barre and Herschel Grossman For the fifth experiment the Fed was assumed should be noted. In the Barre-Grossman to behave according to an estimated equation. model, prices and wages are not decision The behavior that is reflected in this equation variables of firms (or any other agents), and is behavior in which the Fed “leans against no explanation is provided as to why it is that the wind.” As the economy expands or as 88 AMERlCAN ECONOMIC ASSOCIATION MAY ,979 inflation increases, the Fed is estimated to Higher long-term rates have, other things cause interest rates to rise. being equal, a contractionary effect on the The results of these experiments are briefly economy, and this is the main reason for the as follows. When the Fed behaved according smaller increases in real output in Model 2 to the estimated equation, the sum of the than in Model 1. For Mode1 3 the sum of the increase in real output over the first twelve output increase was 61 percent of the sum for quarters after the fiscal policy change was 61 Model I. In Model 3 people also know that percent of the sum when the bill rate was kept profits are going to be higher in the future as unchanged. When the money supply was kept a result of the stimulus, and this information unchanged, the sum was 45 percent of the gets incorporated immediately into stock sum in the constant bill-rate case. The most prices. Stock prices are thus higher in Model expansionary case was the one in which the 3 than they are in Model 2, and this leads, amount of government securities outstanding through a wealth effect on the household was kept unchanged. In this case the govern- sector, to a slightly more expansionary econ- ment deficit that results from the fiscal policy omy in Model 3 than in Model 2. This change is tinanced by an increase in high difference is, however, much smaller than the powered money. The sum in this case was 107 difference between the results for Models 1 percent of the sum in the constant bill-rate and 2, and so in this sense expected future case.