Government spending multipliers in good times and in bad: Evidence from US historical data

Valerie Ramey, Sarah Zubairy

There is no consensus among economists about the size of the multiplier of government purchases. It is not clear either how multipliers vary with the state of the economy. This column presents new evidence on this issue using large historical data set from the US. The findings suggest that there is no evidence that fiscal multipliers differ by the amount of unemployment or the degree of monetary accommodation.

What is the multiplier on government purchases? The policy debates during the Great Recession have led to an outpouring of research on this question and there is still a lack of consensus among economists. Most studies using aggregate post-WWII data have found estimates of modest multipliers, often below unity. If multipliers are indeed this low, they suggest that increases in government purchases are unlikely to stimulate private activity and that fiscal consolidations that involve spending decreases are unlikely to do much harm to the private sector.

Despite the low estimated aggregate multipliers, many economists and policymakers continue to believe that government spending can be a powerful stimulus to the economy. An important source of this belief is the US experience during WWII. The unemployment rate remained at very high levels through the 1930s but fell significantly once government spending rose during WWII. Figure 1 shows that the unemployment rate (defined here to include those employed by New Deal programmes) was 15% before the outbreak of WWII in 1939 but then collapsed to only 1% by 1944. Over this same period, real government purchases rose almost 6-fold, and this increase was accompanied by very accommodative monetary policy that kept interest rates near zero.

Figure 1. Unemployment rate and real government spending in the US, 1938-1946

Why then do so many estimates suggest modest multipliers? One possibility is that the size of the multiplier depends on the economic state. Many researchers and policymakers alike have argued that multipliers could be higher during times when unemployment rates are high or when interest rates are at the zero lower bound. Indeed, recent theoretical research has suggested that government spending multipliers can be much larger when the interest rates are at the zero lower bound (e.g. Woodford 2011, Eggertsson 2011, and Christiano et al. 2011, among others).

Previous work has used post-war US data to investigate whether multipliers depend on the state of the economy (e.g. Auerbach and Gorodnichenko 2012). As Figure 2 shows, however, the post-WWII period was a relatively tranquil time in terms of fluctuations in government spending and unemployment. Can we get more insight into government spending multipliers and how they vary with the state of the economy if we expand our data to include the earlier turbulent periods? This is what we did in a series of papers (Owyang et al. 2013, Ramey and Zubairy 2014).

Figure 2. Government spending, unemployment rate, and the three-month T-bill rate in the US for our full sample, 1889-2013

Note: The vertical lines indicate major military events: 1898q1 (Spanish-American War), 1914q3 (WWI), 1939q3 (WWII), 1950q3 (Korean War), 1965q1 (Vietnam War), 1980q1 (Soviet invasion of Afghanistan), 2001q3 (9/11).

Using historical data to identify state-dependent effects in fiscal multipliers

In Ramey and Zubairy (2014), we exploit the information in historical data to test whether the government spending multipliers differ based on two potentially important features of the economy:

The amount of slack in the economy, which we measure by the unemployment rate; and

Whether interest rates are near the zero lower bound.

We constructed a quarterly historical data set, extending back to 1889, resulting in a sample that includes episodes of huge variations in government spending, wide fluctuations in unemployment, prolonged periods near the zero lower bound of interest rates, and notably includes both the World Wars and the Great Depression period.

In order to identify a government spending shock that is not only exogenous to the state of the economy but is also unanticipated, we use narrative methods to extend Ramey’s (2011) defence news series. This news series focuses on changes in government spending that are linked to political and military events, since these changes are most likely to be independent of the state of the economy.

In addition to our extended sample, our methodology also differs from that used by most in the literature. Rather than estimating regime-switching models, we estimate our state-dependent models using Jorda’s (2005) local projection method. This method offers a simple solution to some of the thorny issues that arise in many non-linear models. In particular, most previous studies compute regime dependent multipliers under the assumption that the economy stays in a particular state for a long time. The methodology we use bypasses these issues since it computes the average effect of increased spending on GDP in a given state at each horizon, and thus takes history – which might include evolution between different states – and also feedback effects of government spending into account.

No evidence of state dependence in fiscal multipliers

First, we address the question of whether the size of the government purchase multiplier depends on the amount of slack in the economy. We define an economy to be in a slack state when the unemployment rate is above some threshold. For our baseline results, we use 6.5% as the threshold based on the US Federal Reserve’s choice of that value in its recent policy announcements.1

Similar to many pre-existing studies, we find that output responds more robustly during high unemployment states. However, we find that government spending also has a stronger response during those high slack periods. The multiplier relevant for policymakers is one that compares the cumulative output response to the cumulative path of government spending. Consequently, the larger output response during the high unemployment state does not imply a larger government spending multiplier.

Overall, we find no evidence that the multiplier on government purchases is higher during high unemployment states. Most estimates of the multiplier are between 0.6 and 1.

We perform extensive robustness checks with respect to our measures of state, sample period, identification method, and the behaviour of taxes and find little change in the estimates.

Another advantage of our longer sample is that it also includes prolonged periods when interest rates are near the zero lower bound or when monetary policy is extremely accommodative of fiscal policy. We define zero lower bound or extended monetary accommodation times to be 1932Q2 – 1951Q1 and 2008Q4 – 2013Q4 (the end of our sample).2

We find multipliers less than one across both states in this case too.

In addition, we do not find convincing evidence of significantly higher multipliers during periods at the zero lower bound or constant interest rates.

The only case in which the multiplier noticeably exceeds unity in the zero lower bound state is when we exclude the rationing periods of WWII. However, these estimates are imprecise and not robust to simple generalisations of the specification.

Concluding thoughts and policy implications

Our findings suggest that there is no evidence that fiscal multipliers differ by the amount of slack in the economy or the degree of monetary accommodation. These results imply that, contrary to recent conjecture, government spending multipliers were not necessarily higher than average during the Great Recession. Our estimates imply that government spending during WWII lifted the economy out of the Great Depression, not because multipliers were so large, but because the amount of government spending was so great.

References

Auerbach, A and Y Gorodnichenko (2012), “Measuring the Output Responses to Fiscal Policy”, American Economic Journal: Macroeconomics 4(2): 1–27.

Christiano, L, M Eichenbaum, and S Rebelo (2011), “When Is the Government Spending Multiplier Large?” Journal of Political Economy 119(1): 78 –121.

Eggertsson, G B (2011), “What Fiscal Policy is Effective at Zero Interest Rates?” NBER Macroeconomics Annual 25: 59–112.

Jorda, O (2005), “Estimation and Inference of Impulse Responses by Local Projections”, American Economic Review 95(1): 161-182.

Owyang, M, V A Ramey and S Zubairy (2013), “Are Government Spending Multipliers Greater during Periods of Slack? Evidence from Twentieth-Century Historical Data”, American Economic Review Papers and Proceedings 103(3):129-34, May.

Ramey, V A (2011), “Identifying Government Spending Shocks: It’s All in the Timing”, Quarterly Journal of Economics 126(1): 51–102.

Ramey, V A and S Zubairy (2014), “Government Spending Multipliers in Good Times and in Bad: Evidence from U.S. Historical Data,” NBER Working Paper No. 20719

Woodford, M (2011) "Simple Analytics of the Government Expenditure Multiplier," American Economic Journal: Macroeconomics 3(1):1-35.

Footnotes

We also conduct various robustness checks using different thresholds, including different threshold values and time-varying threshold.

2 1932Q2-1951Q1 corresponds to a period where there were large deviations of interest rates from those prescribed by the Taylor rule in a sustained way during most of the 1930s and 1940s. We end the early spell in 1951Q1 because the Treasury Accord, which gave the Fed more autonomy, was signed in March 1951.