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According to recent estimates by Susan Woodward and Robert Hall, an extra dollar of government purchases raises GDP by one dollar—so there is little evidence for a “multiplier effect” in the short run, but also little evidence for “crowding out” in the short run. (Perhaps both effects are at work, but they just happen to balance out in practice.) Let’s use these estimates as a rule of thumb to solve the following economic puzzles:
U.S. GDP is about $14 trillion and the Solow growth rate is 3%. Assume that a decrease in aggregate demand caused the growth rate to be only 1%. If Congress wants to return growth to the Solow growth rate and thus move the economy back onto the LRAS curve by increasing government purchases, how big of an increase in government purchases should it enact to close the gap?
Canadian GDP is about $1.2 trillion (U.S. dollars) and the Solow growth rate is 3%. If Canadian GDP experiences a positive aggregate demand shock causing growth to be 6% and the Canadian Parliament wants to change government purchases to return to the Solow growth rate, what change in government purchases should it enact, measured in U.S. dollars?
How do your answers to parts (a) and (b) change if there is stronger crowding out effect from government spending causing the multiplier to fall to 0.5? (In other words, a rise in G of $1 raises GDP by only $0.50.) Answer in U.S. dollars.
How do your answers to parts (a) and (b) change if there is a bigger multiplier effect on consumer spending from government spending and the multiplier rises to 2? (In other words, a rise in G of $1 raises GDP by $2.) Answer in U.S. dollars.
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