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:
a. U.S. GDP is about $14 trillion. In a typical recession, GDP is about 2% below the Solow growth rate as given by the LRAS curve. 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 a rise in government purchases should it enact? Give your answer in dollars.
b. Canadian GDP is about $1.2 trillion (U.S. dollars). If Canadian GDP is 3% above its Solow growth rate, 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?
c. How do your answers to parts a and b change if there’s stronger crowding out, and the multiplier falls to 0.5? (In other words, a rise in G of $1 raises GDP by only $0.50.) Answer in U.S. dollars.
d. How do your answers to parts a and b change if there’s a bigger multiplier effect on consumer 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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