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How Much Does Government Spending Boost Aggregate Employment?

Tuesday, November 10, 2015
government spending aggregate employment

By William Dupor, Assistant Vice President and Economist

Macroeconomists have varying opinions about the effectiveness of the government at boosting economic activity. Take the American Recovery and Reinvestment Act for example. The nonpartisan Congressional Budget Office has produced a series of studies that, taken together, implied that the $840 billion stimulus may have created as many as 5 million or as few as 1 million jobs over its first two years.1

In a new paper,2 I tackled the question of the stimulative effects of government purchases by looking at more than 40 years of state-level data on federal military spending. These data provide a great starting point for this kind of analysis. One reason is that there are extensive historical records showing how much and from where the government buys military goods.

I used a methodology called the local multiplier approach,3 and asked if states that received more dollars in military contracts experienced better employment growth, after controlling for other differences across states. I found that the answer to this question is yes. As other studies have shown, the local effect of military spending on employment was quantitatively (and statistically) significant.

National Effects

However, this finding is only indirectly related to an object of particular interest to macroeconomists: the economy-wide effect of military spending. This is because of potential spillovers across states. For example, suppose the Defense Department buys goods in California and this spending leads to inflows from some workers in Oregon. There would be a negative spillover of spending in California on employment in Oregon. In this example, the aggregate effect of military spending would be less than the local effect because of negative spillovers. In simple terms, the negative effect on Oregon would partially offset the positive effect on California.

I measured the extent of potential spillovers (either positive or negative) by estimating the impact of national defense spending on a state's employment after controlling for that state's own defense spending. I found a negative relationship: State employment tended to be lower (holding state defense spending fixed) when nationwide federal spending was high. This indicated a negative spillover effect on employment. Once the offsetting negative spillover effect was added to the positive local effect, the total macroeconomic effect of defense spending on employment was substantially smaller than the local effect and also not statistically different from zero.

While a definitive source for this negative spillover is not yet clear, it is consistent with cross-state reallocation of resources in response to spending shocks. According to this explanation, when national military spending increases (holding a state's spending fixed), individuals in that state may emigrate in search of opportunities created by military spending elsewhere.

This negative spillover implies military spending (and perhaps government spending more generally) may not be a useful way to boost employment at the national level.

Notes and References

1 "Estimated Impact of the American Recovery and Reinvestment Act on Employment and Economic Output," Congressional Budget Office (various quarterly reports). Dupor, William; and Conley, Timothy Guy. "The American Recovery and Reinvestment Act: Solely a Government Jobs Program?" Journal of Monetary Economics, 2013, Vol. 60, Issue 5, pp. 535-49. For additional information, see also Dupor, William. "What Do Macroeconomists Think about the Impact of Fiscal Stimulus?" St. Louis Fed On the Economy, Oct. 27, 2014.

2 Dupor, William. "Local Fiscal Multipliers, Negative Spillovers and the Macroeconomy." Working Paper 2015-026A, Federal Reserve Bank of St Louis, September 2015.

3 The local multiplier approach infers the effect of fiscal policy by comparing the relative economic outcomes of states that received very little fiscal aid to those that received a large amount of aid.

Additional Resources

Posted In Labor  |  Tagged william duporamerican recovery and reinvestment actlaboremploymentgovernment spending