The macroeconomic effects of government purchases and taxes in neoclassical models of a real economy

From a methodological point of view, standard neo-Keynesian IS - LM analysis of the macroeconomic effects of fiscal policies is rather problematic. The reason is that this analysis is fundamentally static and lacks microeconomic foundations. Moreover, this analysis focuses too heavily on the financial effects of fiscal policies as opposed to their real effects. As a result, a neoclassical alternative pioneered by Auerbach and Kotlikoff (1987) was introduced. Although Auerbach - Kotlikoff (AK) models of fiscal policy impacts are dynamic equilibrium models, they are deterministic. Consequently, AK -type models are not very reliable in terms of their predictive power. To improve the capatibility of neoclassical models to simulate the impacts of fiscal shocks, real business cycle (RBC) models with a government sector are employed. The results of various quantitative tests indicate that in the RBC framework, the presence of a government sector enhances the sensitivity of macroeconomic Variables to aggregate productivity fluctuations. There is also strong evidence confirming the hypothesis that because the fiscal authorities are not capable of designing optimal tax and spending programs, they have to design an ex post remedy for the policy generated market failure.