Increasing Government Purchases to Stimulate the Economy: The Obama Spending Plan

From: Mankiw, 2009  & 2012


When President Barack Obama took office in January 2009, the economy was suffering from a
significant recession. (The causes of this recession are discussed in a Case Study in the next
chapter.) Even before he was inaugurated, the president and his advisers proposed a sizable
stimulus package to increase aggregate demand. As proposed, the package would cost the federal
government about $800 billion, or about 5 percent of annual GDP. The package included some tax cuts
and higher transfer payments, but much of it was made up of increases in government purchases of
goods and services.

Professional economists debated the merits of the plan. Advocates of the Obama plan argued that
increased spending was better than reduced taxes because, according to standard Keynesian theory,
the government-purchases multiplier exceeds the tax multiplier.

The reason for this difference is simple: when the government spends a dollar, that dollar gets
spent, whereas when the government gives households a tax cut of a dollar, some of that dollar
might be saved. According to an analysis by Obama administration economists, the government
purchases multiplier is 1.57, whereas the tax multiplier is only 0.99. Thus, they argued that
increased government spending on roads, schools, and other infrastructure was the better route to
increase aggregate demand and create jobs.

Policymakers focused on three kinds of spending. First, there was spending on “shovel-ready”
projects. These were public works projects such as repairs to highways and bridges on which
construction could begin immediately, putting the unemployed back to work. Second, there was
federal aid to state and local governments. Because many of these governments are constitutionally
required to run balanced budgets, falling tax revenues during recessions can make it necessary for
them to lay off teachers, police, and other public workers; federal aid prevented that outcome or,
at least, reduced its severity. Third, there were increased payments to the jobless through the
unemployment insurance system. Because the unemployed are often financially stretched, they were
thought to be likely to spend rather than save this extra income. Thus, these transfer payments
were thought to contribute more to aggregate demand—and thereby production and employment—than tax
cuts would.

Other economists were more skeptical about the plan. One concern was that spending on
infrastructure would take time, whereas tax cuts could occur more immediately. Infrastructure
spending requires taking bids and signing contracts, and, even after the projects begin, they can
take years to complete. The Congressional Budget Office estimated that only about 10 percent of the
outlays would occur in the first nine months of 2009 and that a large fraction of outlays would be
years away. By the time much of the stimulus went into effect, the recession might be well over.

In addition, some economists thought that using infrastructure spending to promote employment might
conflict with the goal of obtaining the infrastructure that was most needed. Here is how Gary
Becker, the Nobel Prize–winning economist, explained the concern on his blog:

Putting new infrastructure spending in depressed areas like Detroit might have a big stimulating
effect since infrastructure building projects in these areas can utilize some of the considerable
unemployed resources there. However, many of these areas are also declining because they have been
producing goods and services that are not in great demand, and will not be in demand in the future.
Therefore, the overall value added by improving their roads and other infrastructure is likely to
be a lot less than if the new infrastructure were located in growing areas that might have
relatively little unemployment, but do have great demand for more roads, schools, and other types
of long-term infrastructure.

While Congress debated these and other concerns, President Obama responded to critics of the bill
as follows: “So then you get the argument, well, this is not a stimulus bill, this is a spending
bill. What do you think a stimulus is? That’s the whole point. No, seriously. That’s the point.”
The logic here is quintessentially Keynesian: as the economy sinks into recession, the government
is acting as the demander of last resort.

In the end, Congress went ahead with President Obama’s proposed stimulus plans with relatively
minor modifications. The president signed the $787 billion bill on February 17, 2009.

It is impossible to know for sure what effect the stimulus in fact had. Because we get only one run
at history, we cannot observe the counterfactual—the same economy without the stimulus package. One
thing is clear: While the economic downturn of 2008–2009 was severe, it could have been worse. As
judged by the fall in GDP or rise in unemployment, it did not approach the magnitude of the

Great Depression of the 1930s.