Question

A study by the management consulting company McKinsey \& Company recommended that the federal government increase spending on infrastructure, such as bridges and highways, by between \(\$ 150\) and \(\$ 180\) billion per year. The study estimated that the result would be an increase in GDP of between \(\$ 270\) billion and \(\$ 320\) billion per year. What is the implied value of the multiplier if the McKinsey study's estimate of the effect of infrastructure spending on GDP is correct?

Short answer

The implied value of the multiplier is between 1.5 and 2.13.

Step-by-step solution

Identify the Lower bound and Upper bound of Spending and GDP Increase

The lower bound of spending is \$150 billion and the upper bound of spending is \$180 billion per year. Likewise, the lower bound of GDP increase is \$270 billion and the upper bound of GDP increase is \$320 billion per year.

Calculate the Lower bound and Upper bound of the Multiplier

The lower bound of the multiplier can be calculated by dividing the lower bound of the GDP increase by the upper bound of the spending since it gives the minimum value of the multiplier. Similarly, the upper bound of the multiplier can be calculated by dividing the upper bound of the GDP increase by the lower bound of the spending, since it gives the maximum value of the multiplier. Therefore, the lower bound of the multiplier = \(\frac{270}{180}\) = 1.5 and the upper bound of the multiplier = \(\frac{320}{150}\) = 2.13.

Interpret the Result

The value of the multiplier varies from 1.5 to 2.13. That means, an increase in government spending on infrastructure will increase GDP by 1.5 to 2.13 times the amount of spending.

Key concepts

Government Spending

Understanding the impact of government spending is crucial for grasping the fundamentals of how a government can influence a nation's economy. In the scenario provided by McKinsey & Company, the federal government is advised to increase its spending on infrastructure. When the government decides to inject money into the economy, particularly through infrastructure projects such as building bridges and highways, it does so with the intent to fuel economic activity.

Increased government spending can lead to job creation, as these projects require labor. Moreover, it improves the efficiency of transportation and logistics, which benefits businesses and can lead to further economic growth. This spending becomes income for construction companies, workers, and suppliers, who then spend this income on other goods and services, creating a cascade of economic activity known as the multiplier effect.

GDP Growth

GDP, or Gross Domestic Product, is a measure of all goods and services produced within a country's borders and serves as a comprehensive scorecard of a country's economic health. The McKinsey study's prediction that an increase in infrastructure spending could boost the GDP significantly indicates the powerful influence such investments have on economic activity.

When the government spends more on infrastructure, it can enhance the productivity of industries by reducing transportation costs, shortening delivery times, and improving supply chain reliability. This increased efficiency can lead to higher output and sales, which contributes to GDP growth. By calculating a GDP increase range of between \(270 billion and \)320 billion from a spending boost of \(150 billion to \)180 billion, we can anticipate substantial economic benefits.

Infrastructure Investment

Infrastructure investment is seen as a cornerstone for long-term economic prosperity. Investing in infrastructure not only provides immediate benefits, such as employment opportunities, but also paves the way for sustained economic growth. In our given exercise, the proposed investment amounts are substantial, between \(150 billion and \)180 billion per year, but the returns are potentially even greater.

The effectiveness of infrastructure spending can be observed through the improved functionality of transport and communication networks, which facilitates trade and opens up regional markets for business expansion. Moreover, adequate infrastructure is fundamental for public services, enhancing the quality of life for citizens and making a location more attractive for investment by private enterprises.