The neoclassical approach, on the other hand, argues that wartime expenditures can affect the economy through intertemporal substitution, but only when the increase in military expenditure is temporary; see, for example, Barro (1981). If expenditures increase permanently, then private consumption and investment would decline, thereby offsetting the positive effect of military expenditure growth on the economy.
Wars are also linked to inflation, mainly by creating excess demand through military spending. Wars can also lead to commodity price shocks, with a direct impact on inflation. Moreover, the mere fact that wars are generally associated with higher inflation tends to raise inflationary expectations and thus also creates indirect inflationary pressures. The initial state of the economy also matters; when output is considerably below potential, war-related expansionary fiscal policy should not generate a major inflationary shock. (Dornbusch, 2001).
With respect to the U.S. historical experience, most of the results listed above hold with some exceptions. During World War II, a war fought on foreign soil, fiscal policy was much more expansionary than during other wars, reflected in the rapid growth of GDP of almost 12 percent per annum during 1941-1945. Government expenditures during this war were financed mainly by issuing debt, with inflation accelerating as a result of excess demand to slightly more than 5 percent.
During the Korean War (1950-53), government expenditures were financed by higher capital and labor taxes, and GDP growth and inflation averaged around half their World War II levels.
The growth effect of the Persian Gulf War contrasted sharply with previous wars in that, instead of embarking on a war boom, the U.S. economy slipped immediately into recession following the Iraqi invasion of Kuwait in August 1990. One reason for this was that the fiscal stimulus was very small, while, on the other hand, private sector confidence eroded sharply. Oil prices rose sharply over the next two months, with Brent crude oil reaching a monthly average of 36 dollars per barrel in October, which helped contribute to the 1990 recession. Stock prices also fell sharply, as witnessed in the 15-percent decline in industrial share prices between August and October 1990. However, shortly thereafter it became clear that there would not be a significant impact on oil supplies to industrial countries and that a quick victory over Iraq was imminent. As a result, in November, oil prices started to fall and equity prices rise, and by March 1991 the recession had officially ended.
