Multiplier Effects of Government Spending: A Tale of China

Government spending plays an emportant role in determining economic performance in China. As an example, China's rapid recovery during the recent world financial crisis was due to its aggressive 4-trillion RMB government stimulus program. However, China's government spending programs are also known for their notorious inefficiency and inflationary consequences (such as building highways that lead to nowhere and ghost towns that nobody wants to live). This paper quantifies the macroeconomic effects of government spending in China. We show that (i) government spending in China Granger-causes output and investment booms as well as inflation, and (ii) it has a multiplier close to (or larger than) 3. The large multiplier effects are found not only in aggregate time series data but also in panel data at the provincial level. We provide a theoretical model with market failures and Monte Carlo analysis to rationalize our empirical findings. Specifically, we build a model that can generate boom-bust cycles and multiplier effects similar to those observed in China, and use the model as a laboratory (data generating process) to gage whether structural VARs can yield consistent estimates of the theoretical multiplier in short samples. Our Monte Carlo analysis supports the large multiplier found in China.