Wednesday, February 4, 2009

Economic Stimulus 101

Let’s start with what you know: The economy is not doing so well. The government is trying to do something to help the economy get going. The options are cut taxes, spend money, or buy bad assets.

What’s the debate? Which method is best.

How do Economists determine which method is best? They look at the multiplier.

What is the multiplier? It is the number of dollars the economy increases for each dollar extra spent by the government.

Can you give an example? Imagine the government sends you a check for $100.
Typically, you would go and spend some of that $100 (let’s say on a massage and save some. Let’s say you buy an $80 massage, the masseuse takes that $80 then uses it to buy a nice meal at a restaurant let’s say for $64 (he saves the other $16). Now $144 (=$80 + $64) dollars have been spent from that first $100. Imagine the waiter at the restaurant gets another hair cut (after saving some) then the barber buys some books….ect. Each time some of the money is spent and some is saved.

So what is a typical multiplier in an Intro to Econ textbook? Greg Mankiw's NY Times OP ED (here) points out that for government spending a typical multiplier is 1.4 (for every dollar spent 1.4 dollar increase in GDP). He also points to a paper by Obama Economic adviser Christina Romer, who showed that decreasing taxes has a multiplier of around 3.

But is this a typical time? No

So do we have an idea what the multiplier is under the current conditions? Maybe, an idea but who knows.
OK so no one knows, but where can I follow the debate? I’m reading (Greg Mankiw, Marginal Revolution, Brad DeLong, Megan McCardle, and Paul Krugman)

So why not instead pay off people’s credit card bills and mortgages, isn’t this also a credit crisis? (suggestion from the Daily Show via Grinnell friend Paul Carlson) Yes it is a credit crisis. But the goal of the stimulus is to increase spending. Paying off debt, probably has a lower impact (smaller multiplier) than the other options.

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Dan R. said...

But Seth, isn't it also the case that multipliers are marginal and are not linear functions? Otherwise we could just pass a $100 trillion stimulus package and really see the economy take off! Clearly, this is a silly idea. So even if the multiplier is 1.57 on the first billion, it's probably not the same on the last billion and may in fact not even be positive.

Seth Gitter said...


Good point, if it gets too large it may crowd out other impacts. It is also possible if the stimulus is too small, then people will be worried it won't work and will save a larger percentage. So the multiplier could be larger or smaller for different amounts of money.