The Obama administration’s focus on infrastructure spending raises the natural question of the effect of government purchases on total GDP. Does government spending stimulate other categories of spending, especially consumer spending? Or does government spending displace other categories, so GDP rises by less than the amount the government spends?
Valerie Ramey has written a paper with the results of her recent work on the question and with a full bibliography of earlier work. Her answer is that consumption and other categories stay about the same when the government spends more. In other words, the increase in GDP is about equal to the increase in govenment spending. To focus on changes in government spending that are not themselves responding to conditions in the economy, she considers military spending. She finds that GDP rises by about the same amount as an increase in military spending.
The picture below shows GDP and government military spending during World War II, both adjusted for price changes, detrended, and rescaled to the level of the U.S. economy today. If you think that the Obama administration is ambitious in spending a trillion dollars over several years on infrastructure projects, note that military spending maxed out at $7 trillion per year during the war, rescaled to the current size of the economy. During the expansion, GDP rose pretty much the same amount as did military spending. Consumption and other components of spending neither rose under the military stimulus nor fell because of displacement by military spending. The two forces offset one another. Notice, however, that when military spending fell after the victory, GDP did not fall nearly as much. Consumption and other components expanded rapidly to take up the resources freed from military activities and there was little sign of adverse effects from the lower military spending.
The second picture shows the same variables for the buildup at the beginning of the Korean war. The story is much the same-equal increases in military spending and GDP.
Although military spending expanded in three other episodes-Viet Nam, the Reagan buildup, and post 9/11-none of these expansions was large enough to give much additional evidence on the response of GDP to increases in military spending.
We believe that the one-for-one rule derived from wartime increases in military spending would also apply to increases in infrastructure spending in a stimulus package. We should not count on any inducement of higher consumption from the infrastructure stimulus but we should also not worry that infrastructure spending might displace consumption and other categories of spending.