by Mario Rizzo
Let’s assume for the sake of argument that, initially, increased government expenditure does stimulate a meaningful measure of national income. Is this sustainable? In other words, will the private sector be jump-started by this action such that when the temporary government expenditure is eliminated private consumption and investment will replace it? The following piece of evidence from Greg Mankiw’s recent article in the New York Times casts doubt on sustainability.
In practice, however, the multiplier for government spending is not very large. The best evidence comes from a recent study by Valerie A. Ramey, an economist at the University of California, San Diego. Based on the United States’ historical record, Professor Ramey estimates that each dollar of government spending increases the G.D.P. by only 1.4 dollars. So, by doing the math, we find that when the G.D.P. expands, less than a third of the increase takes the form of private consumption and investment. Most is for what the government has ordered…(Emphasis added).
Mankiw does not give a reason for this but Robert Murphy in the piece linked to in the post below seems to provide an answer. Why would people make long-run adjustments to what they perceive as temporary allocations of capital?