Estimating the Effect of Fiscal Policy on Output Suppose an economist finds that

Question

Estimating the Effect of Fiscal Policy on Output

Suppose an economist finds that government spending is negatively correlated with output growth. That is, in periods in which government spending is greater than normal that output growth is, on average, relatively low and in periods in which government spending is less than normal that output growth is, on average, relatively high. Should we take this as evidence against a Keynesian model in which an increase in government spending leads to an increase in output? Explain your answer.

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Explanation / Answer

The negative correlation between higher government expenditure and output growth is not an evidence against the Keynesian model in which an increase in government expenditure leads to an increase in output growth. This is because the effect of government expenditure on output growth happens with a lag. This means that government expenditure increase in the current year will not have any impact on the output growth observed this year. In fact goverment expenditure in the previous year or before may facilitate output growth in the current year. Therefore, in order to test the validity of the Keynesian hypothesis, we must look at the correlation of governmnt expendure in the past years with the output growth in the current year. The lag with which the government expenditure affects economic growth depends on various public institutions on which the spending is done and the speed with which they facilitate output growth. Taking these factors into consideration, we need to look for the lagged effect of government expenditure on output growth. If this is still found to be negative, it may indicate evidence against the Keynesian hypothesis.

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