Monday, January 26, 2009

Barro On Stimulus and Multipliers

Robert Barro, a Harvard professor (faculty website), has a lock on a Nobel Prize in economics for his work in macroeconomics over the last 40 years.

In the January 22 issue of The Wall Street Journal he had an op-ed piece entitled "Government Spending Is No Free Lunch". It focuses on the value of the multiplier that Keynesian theory suggests enhances government spending.

... Team Obama is reportedly using a number around 1.5.

To think about what this means, first assume that the multiplier was 1.0. In this case, an increase by one unit in government purchases and, thereby, in the aggregate demand for goods would lead to an increase by one unit in real gross domestic product (GDP). Thus, the added public goods are essentially free to society.

If the multiplier is greater than 1.0 ... the process is even more wonderful. In this case, real GDP rises by more than the increase in government purchases. Thus, in addition to the free airplane or bridge, we also have more goods and services left over to raise private consumption or investment. In this scenario, the added government spending is a good idea even if the bridge goes to nowhere, or if public employees are just filling useless holes. Of course, if this mechanism is genuine, one might ask why the government should stop with only $1 trillion of added purchases.

FWIW: There has been considerable scuttlebutt in the economics blogs this past week about this article: there have been a lot of personal insults of Barro without refutations of his basic point.

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