Why Do Economists Still Disagree Over Government Spending Multipliers?

Public debate about the effects of government spending heated up after record-large stimulus packages were enacted to address the fallout of the financial crisis. Almost as noticeable as the discord was the absence of consensus among prominent economists on the issue. While it seems a simple problem to estimate the effect of government spending on output—the size of the government multiplier—it is anything but.

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Over the past several years, attention has focused on the dangers of medium- and long-run imbalances in government budgets. This was less the case at the beginning of the recent financial crisis, when the question was if and how the government should try to stimulate the economy. But before long, the debate surfaced. Some argued that the government should prop up falling private demand with increased spending. Others claimed that increased government spending would have little to no stimulative effect in the short run and that it might even be contractionary.

Economists could offer little in the way of clarification, with venerated scholars falling on both sides of the debate. This failure of economists to agree on the issue leads some in the public to suppose that economists are incompetent, or perhaps worse, politically motivated.

The truth is that economists have struggled to answer the question, “What effect does an increase in government spending today have on output in the future?” In economics, this effect is called the government spending multiplier, and unfortunately for those of us who would like certainty on the matter, there are major challenges associated with measuring it. An appreciation for these challenges should explain why competent scholars can hold widely different opinions about the effect of government spending on output.

Measurement Challenges

Problems with measuring the government spending multiplier begin at the outset—with the way the question itself is phrased. At first, it seems like a natural question, but in fact it is far too general.

For starters, it is presumptuous to speak of “the” government spending multiplier as if there is only one. Because a change in government spending is likely to influence output over multiple periods in the future, separate multipliers could be created for each period. To calculate the appropriate multiplier, should we look at how much output changes one quarter in the future? One year? Five years? There is no universally accepted answer. Some studies report a collection of multipliers over a specific time period (for example, a multiplier for each quarter up to three years). Others average these numbers or report a range.

Taking a stand on timing is not sufficient however. One must also consider what type of government spending is increased. Surely an increase in military spending or spending on equipment will have a different effect on future output than an increase in infrastructure spending, education, or research. In practice, stimulus programs contain a mixture of spending types, so no two episodes are exactly the same. Most theoretical studies look at just the total level of spending and ignore these different uses. A few have separated government spending into spending on consumption goods (like automobiles) and spending on investment goods (like infrastructure).

Our best estimates of the multiplier also depend upon a number of crucial assumptions about the environment in which the spending takes place. Is the economy in a recession? How is spending financed? How is contemporaneous monetary policy conducted? Are markets efficiently allocating resources, or is there room to improve the allocation? How are other countries responding? These are just a few of the important questions about context that affect the size of a multiplier.

Estimating the Multiplier Theoretically

The theoretical approach to estimating the government spending multiplier begins with a model. A model is a simplified representation of the economy designed to mimic aspects that are critical for answering a specific question. A good model includes as few variables as possible, but it must reproduce salient features of the data. A model that fits these criteria can be used like a laboratory to contemplate the circumstances under which government spending would boost GDP.

Models designed to address questions about the government spending multiplier have at least three fundamental components: utility-maximizing households, profit-maximizing firms, and a government. Households have an objective to maximize their utility over a given time horizon, subject to their lifetime budget constraint. That is, their goal is to obtain their most desired mix of goods over time while respecting their budget in every period. A typical budget would include wage income, income from savings, and transfers from the government.

Firms seek to maximize profit by employing workers and capital to create consumption goods, which households, the government, and, in some models, foreign consumers purchase. They also create new capital for use in future production.

The government’s objective varies widely across models. Often it is left unspecified. In this case, the government mechanically raises tax revenues or issues new debt to cover its expenditures in each period. Typical expenditures are transfers to households, payments on outstanding debt, and spending on consumption or investment goods. Only this final activity constitutes “government spending,” and often in models it is set by the researcher and is not determined by interactions of the other parts of the model. Typically, it is set to vary randomly around some trend.

A model containing the ingredients above will lead to the following basic macroeconomic identity, an expression which describes the relationship among the components.

GDP Supplied = Consumption + Investment + Government Spending + Net Exports.

This identity is called the “aggregate resource constraint,” and it simply states that all the production in an economy must be used somewhere. To put it succinctly, supply (the left-hand side) equals demand (the right-hand side). To better understand how government spending might affect GDP, it is helpful to consider how it would affect each component of the identity.