Friday, December 12, 2008

We're all gonna die! (part II)

So the economy is looking worse and worse. Jobless claims are up to their highest levels since the early 1980's, or depending on how you measure it, the 1950's.  Regardless, the recession is on and looking bad.

How do we recover from this?  Well, the federal government is mulling over a large ($800 billion?) fiscal stimulus bill that would have the government start spending on things like infrastructure, health care, etc. to get the economy moving.  The intellectual back-up for this comes from the Keynsian multiplier.  That is, every dollar of government spending becomes income to someone else (a business from whom they bought concrete to build a new road), who then in turn spends this (on your salary), and you spend this on things like TV's and take-out Chinese food.  The original $800 billion stimulus actually generates an extra (1+x)*$800 billion in economic activity. "x" is the Keynsian multiplier, and your average macro textbook will tell you that x could be as big as 1 or 1.5  (So we could get $2 trillion in new economic activity by spending $800 billion). 

This all hinges on the size of x - (by the way, theoretically we think that "x" is bigger for government spending than for tax cuts, so that is why Obama is focusing on spending).  But this site, run by two really good economists reviews some research that suggests that "x" may actually be zero.  That is, $800 billion in government spending could only generate $800 billion in new GDP.   That's still good - but not the bang for the buck that you'd like. 

So when you are listening to the news about the fiscal stimulus, it is useful to realize that much of the discussion can essentially be boiled down to asking how big "x" is.

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