The Multiplier Effect

Posted by Jeff Carter
on May 3rd, 2011

The multiplier effect is how much a dollar spent by the government increases GDP. It also measures how much a tax decrease, or increase increases or decreases GDP. It is a contentious debate among economists.

Keynesians love to say that the multiplier effect of government spending increases GDP by 1.4%. For every dollar spent, you get a corresponding 1.4% bump in GDP. However, Christine Roemer’s own paper disproved that. Krugman left himself a lot of wiggle room back in 2009. He said the stimulus wasn’t big enough. So today since we have seen the abject failure of Obama and the Democrats stimulus package, he can say “I told you so.”

Gary Becker and Kevin Murphy published this article way back when arguing that stimulus will do nothing. If you want to see some math behind their points, the slides are linked here. Tax cuts increase GDP by a factor of 3. For every one percentage decline in taxes, GDP increases by 3%. Of course, there are limits to that. Once you go to 0% taxes, you can’t increase GDP by tax cuts anymore (duh).

It’s important to note that the difference between the two camps is this: Keynesians believe in a central plan (government spending) to ramp up economic activity. Classical economists believe in setting a data driven standard, and then letting entrepreneurial market forces reach that standard.

Now that the data is in. We can make an objective judgement over government spending and the multiplier effect. What has happened is that government spending contributed a net 0 to growth, just like Becker and Murphy posited before the money was spent. In addition, the increase in federal debt has become a drag on the economy, and will eventually increase our borrowing costs. S&P and the rest of the ratings agencies are watching US debt closely.

Keynesian economics ought to be tossed into the dustbin of history. Too bad we can’t have a burial at sea. Too many shrines to it already.

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