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By Byron Gangnes, Rachel Inafuku, and Peter Fuleky
The economic shutdown in Hawaii and elsewhere due to the novel coronavirus has led to sharp reductions in employment and private spending, as well as historically large government fiscal responses. Analysis of the effects of changes in government spending and employment policies requires estimates of how much total economic activity will change as a result of the policy.
Fiscal policy actions have both direct and indirect effects on the economy. The direct effect comes from the increase in demand from the spending itself, or the direct maintenance of employment and income. These direct effects, by raising income and wealth, induce additional spending on goods and services throughout the economy and raise economic activity further. The total impact of both direct and indirect effects is often summarized by fiscal policy multipliers that give the total change in some measure of economic activity per dollar of government spending change.
Estimates of fiscal policy multipliers go back many years, but there was a resurgence of interest during the Great Recession of 2008-2009 and the subsequent recovery. In its advocacy for the 2009 American Recovery and Reinvestment Act, the Obama Administration relied on a multiplier estimate of 1.5, meaning that every $1 of fiscal support would result in a $1.50 increase in real Gross Domestic Product, once indirect effects were felt. This estimate, while well within the range of the existing literature, came under harsh criticism in some quarters, where skeptics insisted that spending by the government could “crowd out” at least as much private sector activity through the adverse effects of increased government borrowing and competition for limited resources.
The debate over multipliers is not surprising, considering the difficulty involved in measuring the effect of a policy change in an economic environment that is rapidly evolving for many other reasons. Over the years, researchers have used a variety of methods to identify and estimate the size of multipliers, including structural econometric models that represent the economy in detail; less structural statistical models; analyses that study the performance of the economy after specific past episodes of policy change; and studies that look at variation in state-level policies. It is safe to say that the resulting range of multiplier estimates is quite large, ranging from slightly negative to 3 or higher.
By our reading and previous modeling experience, we believe the most plausible value for a federal spending multiplier lies above 1 but not more than 2. There is a fairly general consensus that multiplier effects are larger during deep recessions, when private sector activity is weak, and that they depend on the specific type of policy implemented and factors such as business and consumer confidence.
How large is the multiplier in the UHERO econometric model for an increase in government spending here? Recent computations yield a response of about 1.5, consistent with the range of national and state-level studies. Given the severity of the economic downturn, this may well underestimate the true impact at present. That means every dollar of federal spending that comes here has a substantial positive overall economic impact. It also means that any large cuts to federal or state spending would have large adverse impacts, as well.
For further reading see:
Adams, F. Gerard and Byron Gangnes, Why Hasn’t the US Economic Stimulus Been More Effective? The Debate on Tax and Expenditure Multipliers. World Economics, Vol. 11, No. 4, October-December 2010, pp. 111-130.