This article tackles the issue concerning
the repercussion of government spending on aggregate output, a question many
government are facing when designing their fiscal policies.
There are 2 opposing views to this problem,
some economists consider that an increase in the government spending will have
a large multiplier effect whilst other remain skeptical to this idea and say it
could harm the economy.
One major reason for this disagreement is
that it remains very difficult since output is based on a startling array of
factors such as the supply side of the economy itself based on interrelated
factors such as consumer demand or other external factors an open economy faces.
Indeed, both are correlated but this does not necessarily mean there is a
causation between the two. One way to calculate it is to see the percentage
increase in output with the increase in military spending in the 20th
century, this was done for the USA. After doing a regional analysis of the
variation in each state, economists found out that when the relative spending
in a state increases by 1% of the GDP, the relative state GDP rises by 1.5%
Other sub-national variation in spending
were estimated in different parts of the world such as in Italy. It was found
that a decrease in government spending led to a crackdown of the mafia revealing
how corrupt the political system is. This strong link between the two supports
the first idea which insists on the fact that government spending causes output
Nevertheless, we must be careful to not
draw conclusion too rapidly. In the analysis on the USA, the fact that the
state of California had a greater multiplier effect might be because it was not
the state which spent the money. However, if we look at it from another
perspective, the Neoclassical point of view we could draw a whole different
conclusion. Indeed, we would believe that a negative wealth shock in a state
(government spending) would increase the labor supply and thus show a lower
multiplier rather than a higher one.
Also, when government spending are
increased, other national driving forces of the economy are changed (eg. Tax rate
or the interest rate) and have important impacts on the economy. These may
counter the effect of the multiplier effect or tarnish the results.