| The question analyzed in this paper is: how important is the sluggish adjustment of prices and wages for understanding the effect of government purchases on macroeconomic variables? Here, this question is addressed using a quantitative (calibrated) dynamic general equilibrium (DGE) model with money and overlapping price and wage contracts, a la Calvo (1983). A baseline model is considered in which the average duration between price and wage changes (at the micro level) is set at 4 quarters, consistent with empirical evidence on price and wage adjustment. The existing literature on general equilibrium effects of fiscal policy has used Real Business Cycle (RBC) models that abstract from money qnd nominal rigidities; see , e.g., Baxter and King (1983). Recently, there has been much interest in quantitative DGE models with nominal rigidities (e.g., Rotemberg and Woodford (1997)), but that work has abstracted from fiscal policy and focused on the effect of monetary policy shocks. The present paper bridges these two literatures. In the structure here, firms with predetermined prices satisfy any demand addressed to them (at those prices)--the short run supply schedule of these firms is, hence, infinitely elastic. The present analysis stresses, thus, the role of changes in aggregate demand, as a source of short run output fluctuations. The nominal rigidities model gives rise to substantial "Keynesian" multiplier effects of government purchases that are absent in standard RBC models (which stress supply responses to government purchases). Shocks to government purchases might thus be much more important as a source of economic fluctuations than what is suggested by RBC theory. Standard RBC models predict that an increase in government purchases induces a fall in the real wage rate. By contrast, in the structure with sticky prices and wages, an increase in government purchases is predicted to raise the real wage rate, as seems consistent with the data. |