The Keynesian Multiplier

Does the multiplier effect of government spending exist? Robert Barro doesn't seem to think so. He estimates that government spending has a short-term multiplier of around 0.4-0.6: for every dollar of government spending, overall GDP increases by 40 to 60 cents. Moreover, Barro accounts for the fact that government spending must be repaid by the public in the form of taxes. Barro argues that taxes have a multiplier of -1.1 on consumers,resulting in a further shrinking of GDP. His conclusion is that government spending costs more than the benefit it provides.


The most recent research I found on the government spending multiplier effect was published in November of 2010. This paper argues that there is very little multiplier effect. The excerpt below was taken from the introduction of the the paper “In Search of the Multiplier for Federal Spending in the States During the New Deal,” by authors Price Fishback and Valentina Kachanovskaya. They analyzed the period from 1930 to 1940 in order to find out the multiplier effect of large peace-time federal spending.

"Using panel data methods we estimate a multiplier, defined as the change in per capita economic activity in response to an additional dollar per capita of federal funds. For personal income, which includes transfer payments as income, the estimate ranges from 0.91 for the combination of government grants and loans to 1.39 when only grants are considered... The personal income multiplier for public works and relief was around 1.67, while the effect of farm payments to take land out of production reduced personal income by 0.57. Multipliers for a more production-based measure of state income per capita after removing nonwork relief transfers and adding back payroll taxes are about 10 to 15 percent smaller. The multiplier for wages and salaries was substantially less than one, as was the multiplier for retail sales. The impact of the federal spending on employment was negligible and may have been negative."

It appears that in this instance, the multiplier effect was over one at times indicating success in Keynesian theory in describing government policy effects.


However, other economists think differently about the issue. Mark Zandi, the chief economist for Moody's Economy.com, estimated the one-year multiplier effect for several fiscal policy options during a congressional testimony given in July 2008. The results of his studies demonstrated that government spending would have a stronger multiplier effect tax cuts. According to Zandi, the most effective form of government spending in terms of increasing consumption was a temporary increase in food stamps. Zandi provided an estimate of 1.73 for the multiplier effect. On the opposite side of the spectrum, the lowest multiplier for a spending increase was general aid to state governments, with a multiplier of 1.36. The Bush tax cuts had the second-lowest multiplier of any government spending initiative 0.29 whereas lump-sum tax rebates, i.e. the Economic Stimulus Act of 2008, had the second-largest multiplier for a tax cut, 1.26. Among tax cuts, multipliers had much lower multiplier ranges, from a high 1.29 for a payroll tax holiday down to a low 0.27 for accelerated depreciation.

As it stands, the data is divided on whether or not government spending stimulates consumption. It seems that the population with the lowest income will consume food stamps and other basic goods and spend their saved money consuming in the open market. However, corporations that make savings through accelerated depreciation and other tax cuts are not as willing to put saved money directly back into the open market. The money will more likely be reinvested in the company or saved. Barro has been an outspoken opponent of stimulus spending, calling Obama's stimulus bill "garbage" and "the worst bill since the 1930's. Yet, the stimulus bill's spending multiplier was a whopping 1.26 compared to the incredibly low multiplier for the Bush tax cuts. Robert Barro may have been right about certain types of government spending, but his analysis may not be right for all government programs.

Citations:
http://lawafterthebar.wordpress.com/2011/01/26/does-government-spending-have-a-multiplier-effect-on-the-economy/
"Much ado about multipliers". The Economist. Sep 24th 2009.
http://online.wsj.com/article/SB10001424052748704751304575079260144504040.html
Barro, Robert J. (October 1, 2009). ""Stimulus Spending Doesn't Work" Economist Robert Barro, Harvard University, WSJ". The Wall Street Journal.
 Ethan Ilzetzki, Enrique G. Mendoza and Carlos A. Végh "How Big (Small?) are Fiscal Multipliers?" March 2011.
http://www.columbia.edu/~mw2230/G_ASSA.pdf