Question

Why is it so difficult to estimate the effect of Government spending on the economy and how have economists addressed the problems?

Answer 1

It is difficult to estimate the effect of government spending because it is extremely difficult to estimate the spending multiplier accurately. The following are the reasons why it is difficult to measure the multiplier accurately-

1. Period of the multiplier- There is no one multiplier period. Each spending will have its effects over many periods going forward. What is the time period for which one should consider the impact? An year? A quarter? Each will show different impact. Should we have a different multiplier for each period?

2. Type of government spending- Government spending is not a monolith. The government spends on many different things. Spending on military will have far different effect than spending on healthcare. Spending on healthcare will have far different effect than spending on infrastructure. How should one measure on impact of all these spendings and come up with one multiplier to measure the total impact?

3. The inherent assumptions- The measurement of multiplier by itself has lots of assumptions. These include whether there is recession, how will the spending be financed?, are markets efficient? What is the monetary policy at the same time? Each of these assumotions by themselves are very big factors affecting the measurement.

4. Impossibility of expreiments- Economists can't do live experiments like a chemist. They can't stop one sector of economy and then introduce government spending in other sectors and see the impact. They can only rely on past data which itself is a result on all these levers of the economy interacting in a complex manner.

There are a few methods by which economists try to resolve these issues. These include-

1. To solve the period issue, many scientists take different multipliers for different periods, such as quarters. Others average out the different multipliers over a longer timeframe.

2. To solve the type of spending issue, many scientists simply take the total and ignore the different types. Others divide the spending into two types- spending on consumption goods such as buying cars etc and spending on investment goods such as infrastructure etc.

3. Modeling- Economists first build theoretical model and then slowly add real life constraints and conditions in it to see if it fits the available real life data. These conditions include different models for recession and expansion, different model for different type of monetary policy etc. This also includes putting conditions and constraints in statistical models.

4. Focus on specific spendings- There are a few spendings which change not because of a change in GDP or because government wanted expansion. For example, military spending changes because of many other factors and since it might vary in a normal situation also, its effects are slightly easier to isolate.