By Hao Li: Subscribe to Hao's RSS feed
September 4, 2010 3:56 AM EDT
The U.S. government has been spending money to support the ailing economy during and after the Great Recession. There is heated debated on the effectiveness of this policy.
One figure economist used to measure the effectiveness is the fiscal multiplier, which is basically the magnitude by which government spending increases the overall GDP.
If the multiple is greater than 1, then $1 spent by the government generates more than $1 in the GDP, so in this case, it is cost-effective in dollar-for-dollar terms. If the multiplier is negative, then the reverse is true.
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Proponents of government spending, those who think the multiplier is greater than 1, argue government spending leads to private consumption and investment that trickles down several layers.
Opponents of government spending argue that it acts as "competition" that crowds out private investment and spending that would have happened in the absence of it. This is because the government takes away resources from the private sector by either borrowing or taxing to fund its spending.
According to a recent research paper by economists Alan Auerbach and Yuriy Gorodnichenko , the answer to the government spending debate is "it depends."
Government spending works a lot better during recession than during expansion. Indeed, in every period defined as a recession by the National Bureau of Economic Research, the multiplier has been at least 1, according to the study. The multiplier is as high as 2.48 in recessions but only up to 0.57 in expansions.
Intuitively speaking, this makes sense. During expansion, the private sector is looking to invest and spend in response to demand from the economy. But if the government spends, it takes away resources from the private sector and crowds out consumption and investments. During recessions, the private sector lacks demand, so government spending generates that demand, which then trickles through the economy.
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