Question

When a war begins, what happens to the relationship between GDP and potential GDP? Does your answer depend on the size of the war or its duration?

Answer 1

When war takes place, the government increases spending which results in a higher domestic demand, higher output, and lower unemployment rates. This results in a higher real GDP. In the short-run i.e. when the war begins, the real GDP can grow and become equal to or even higher than the potential GDP as the unemployment rates go below the natural rate of unemployment.

The answer depends on the size of the war or its duration as if the size of the war is very small relative to the size of the economy or if the duration is very short, the war efforts may not stimulate the economy significantly. On the other hand, if the war is very large or too long, resources are diverted to military spending which can negatively affect human capital, physical capital, health care, technological developments, etc. These negative effects can result in a fall in real GDP.