Working Papers, Federal Reserve Bank of Boston 15-9
Using 25 years of military spending data from more than a hundred countries, this paper provides new evidence on the effect of government spending on output. Following a popular assumption that military spending is unlikely to respond to output at business-cycle frequencies - and exploiting variation in military spending of a significantly larger magnitude than in the previous literature based on U.S. data - we find that the pooled government spending multiplier is small: below 0.2. This estimate, however, masks substantial heterogeneity: the debtfinanced spending multiplier is larger and can be well above 1 if monetary policy is accommodative. The multiplier is especially large in recessions and when the government purchases durables. We also document substantial heterogeneity across countries with the spending multiplier larger in advanced economies and in countries with a fixed exchange rate. The output response to government spending persists for about two to three years. These findings suggest that the effectiveness of fiscal policy depends largely on the economic environment, policy implementation, and the central bank's response, and that the small multipliers found in historical or pooled data are a poor guide to evaluating the effectiveness of a specific stimulus program.