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Response to Questions about the Effects of Government Spending on Economic Growth 1 (August 11, 2011)

handle is hein.congrec/cbo10573 and id is 1 raw text is: CONGRESSIONAL BUDGET OFFICE Douglas W. Elmendorf, Director U.S. Congress Washington, DC 20515 August 11, 2011 Honorable Tim Huelskamp U.S. House of Representatives Washington, DC 20515 Dear Congressman: I am writing in response to your letter inquiring about the effects of government spending on economic growth. Changes in government spending can affect the economy in two different ways: in the short term, by changing demand for goods and services and over the long run, by changing the potential supply of goods and services. How Federal Spending Affects Aggregate Demand for Goods and Services As the recent severe recession and slow recovery are showing, economic activity can deviate for substantial periods from its potential level in response to changes in aggregate demand (the total purchases of a country's output of goods and services by consumers, businesses, governments, and foreigners). When demand for goods and services falls short of the economy's ability to produce them, as is the case currently, increasing government spending can increase aggregate demand and thereby narrow the gap between the economy's actual and potential levels of output. Most types of government spending have this short-run effect on demand. Government purchases of goods and services add to aggregate demand directly, and government transfers to people (such as unemployment insurance payments or Social Security benefits) or to states and localities (such as support for secondary education) tend to increase the amount of goods and services purchased by the recipients. The magnitude of the effect on demand depends on the details of the spending policies and the economic situation.I For example, when the Federal Reserve's ability to lower short-run interest rates is constrained because those rates are already near zero, as they are currently, the short-run effects of changes in government spending on output tend to be larger than usual. 1See Congressional Bud get Office,EsiaeImctothAeranRovyad March2011(May 2011) and Statement of Douglas W. Elmendorf, Director, Congressional Budget Office, before the Senate Committee on the Budget, TeEooi ulo n Fisal olev hoies(September 28, 2010). www.cbo.gov