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Fiscal multiplier
This article is about the eect of spending on nationalincome.
For the multiplier eect in banking, seeFractional-reserve
banking.
In economics, the scal multiplier (not to be confusedwith
monetary multiplier) is the ratio of a change innational income to
the change in government spendingthat causes it. More generally,
the exogenous spendingmultiplier is the ratio of a change in
national incometo any autonomous change in spending (private
invest-ment spending, consumer spending, government spend-ing, or
spending by foreigners on the countrys exports)that causes it. When
this multiplier exceeds one, theenhanced eect on national income is
called the mul-tiplier eect. The mechanism that can give rise to
amultiplier eect is that an initial incremental amount ofspending
can lead to increased consumption spending,increasing income
further and hence further increasingconsumption, etc., resulting in
an overall increase in na-tional income greater than the initial
incremental amountof spending. In other words, an initial change in
aggregatedemand may cause a change in aggregate output (andhence
the aggregate income that it generates) that is amultiple of the
initial change.The existence of a multiplier eect was initially
proposedbyKeynes student Richard Kahn in 1930 and published
in1931.[1] Some other schools of economic thought rejector downplay
the importance of multiplier eects, par-ticularly in terms of the
long run. The multiplier eecthas been used as an argument for the
ecacy of govern-ment spending or taxation relief to stimulate
aggregatedemand.In certain cases multiplier values less than one
have beenempirically measured (an example is sports
stadiums),suggesting that certain types of government spendingcrowd
out private investment or consumer spending thatwould have
otherwise taken place. This crowding outcan occur because the
initial increase in spending maycause an increase in interest rates
or in the price level.[2]In 2009, because of the use of scal
multipliers to projectthe benets of the American Recovery and
ReinvestmentAct of 2009, The Economist magazine noted economistsare
in fact deeply divided about how well, or indeedwhether, such
stimulus works[3] due to a lack of empir-ical data from
non-military based stimulus. Immediatelyafter the stimulus bill
took eect, job loss slowed andprivate sector job growth resumed in
2010 and has con-tinued through 2012.[4]
1 Net Government SpendingThe other important aspect of the
multiplier is that to theextent that government spending generates
new consump-tion, it also generates new tax revenues. For
example,when money is spent in a shop, purchases taxes such asVAT
are paid on the expenditure, and the shopkeeperearns a higher
income, and thus pays more income taxes.Therefore, although the
government spends $1, it is likelythat it receives back a signicant
proportion of the $1 indue course, making the net expenditure much
less than$1. Indeed, in theory, it is possible, if the initial
expen-diture is targeted well, that the government could
receiveback more than the initial $1 expended.
2 ExamplesFor example: a company spends $1 million to build
afactory. The money does not disappear, but rather be-comes wages
to builders, revenue to suppliers etc. Thebuilders will have higher
disposable income, and con-sumption may rise, so that aggregate
demand will alsorise. Suppose further that recipients of the new
spendingby the builder in turn spend their new income, this
willraise demand and possibly consumption further, and soon.The
increase in the gross domestic product is the sum ofthe increases
in net income of everyone aected. If thebuilder receives $1 million
and pays out $800,000 to subcontractors, he has a net income of
$200,000 and a corre-sponding increase in disposable income (the
amount re-maining after taxes).This process proceeds down the line
through subcontrac-tors and their employees, each experiencing an
increasein disposable income to the degree the newwork they
per-form does not displace other work they are already per-forming.
Each participant who experiences an increasein disposable income
then spends some portion of it onnal (consumer) goods, according to
his or her marginalpropensity to consume, which causes the cycle to
repeatan arbitrary number of times, limited only by the
sparecapacity available.Another example: when tourists visit
somewhere theyneed to buy the plane ticket, catch a taxi from the
airportto the hotel, book in at the hotel, eat at the restaurant
andgo to the movies or tourist destination. The taxi driverneeds
petrol (gasoline) for his cab, the hotel needs to hire
1
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2 3 APPLICATIONS
the sta, the restaurant needs attendants and chefs, andthe
movies and tourist destinations need sta and clean-ers.
3 ApplicationsThe multiplier eect is exploited by governments
at-tempting to use scal stimulus policies to increase thegeneral
level of economic activity. This can be done in aperiod of
recession or economic uncertainty, when unem-ployment of labor is
high and other resources are under-utilized. Increased spending by
government increases therate of aggregate demand, increasing
business activity,which increases income, which further increases
spend-ing and aggregate demand, in a virtuous cycle. The idea
isthat the total increase in production and income by all par-ties
throughout the economymay be greater than the orig-inal increment
to government spending, as additional re-sources are drawn into the
circular ows of money spend-ing and business activity through the
economy. The ex-istence of idle capacity and involuntary
unemploymentof labor in the economy can be represented as an
out-put gapa dierence between actual GDP and poten-tial GDPand a
policy of scal stimulus may aim at in-troducing sucient additional
spending, amplied by themultiplier, to speed the closing of the
output gap.Any additional spending by government must be -nanced,
by drawing down reserves, by additional taxesor by issuing
additional government debt instruments (i.e.borrowing). Increased
taxes exactly matched to increasedspending might seem designed to
draw out of the cir-culating ow of the economy an amount of income
intaxes exactly equal to the amount being injected by ad-ditional
government purchases. Increased borrowing tonance additional
government purchases might also besupposed to be designed to draw
out of the circulatingow an amount equal to the additional
government pur-chases, perhaps by crowding out private borrowing
for in-vestment spending. In the history of economic thought,the
notion that any increase in government spending nec-essarily crowds
out an equal amount of private spendingor investment, through
taxation or borrowing, and thushas no net impact on economic
activity, is known as theTreasury View, and is regarded as
generally fallacious.The argument that the choice of taxes or
borrowing tonance government spending must be equivalent in
thattaxpayers observe borrowing and save in anticipation oftaxes to
repay the borrowing is known as Ricardian Equiv-alence, and is
sometimes cited as a rationale for believingthat scal stimulus
policy will be made futile by the reac-tions of rational consumers
and businesses, reducing theirspending or investing in exact
proportion to increases inpublic spending, in a scenario similar to
that envisionedin the Treasury View.Whether an incremental increase
to government spend-ing will have a multiplier eect is thought to
depend on
circumstances in the economy: rst, particularly on theextent to
which unemployment of resources may be high,so that the additional
demand represented by governmentpurchases may be realized by
additional production andhigher utilization of resources, without
bidding up prices;second, by the state of the nancial and credit
markets,where demand for money and money instruments maywelcome
additional government debt as low-risk securi-ties, but may regard
investment in private production ca-pacity or capital formation as
too risky, given a low levelof general business activity.When
unemployment of resources in the economy ishigh, and cash, in eect,
is being hoarded in the -nancial and credit system, the scal
multiplier may be1 or greater. Even a balanced budget scal
stimulusadditional public purchases fully nanced by equiva-lent
increases in taxation without any additional publicborrowingmay
have a multiplier greater than 1, as theincrease in output and
business activity reduces persistentunemployment and the anxiety
driving hoarding, with re-sulting increases in private consumption
and investmentreducing the time it takes for the economy to return
tofull employment.[5]
Government borrowing to nance additional public pur-chases in
circumstances in which cash is being hoardedin the nancial and
credit system will not displace pri-vate investment spending. An
additional supply of low-risk government securities may simply
provide vehiclesfor continued hoarding as short-term government
secu-rities are regarded as closely equivalent to cash. In
suchcircumstances, policy to increase aggregate demand andtotal
business activity by means of scal measures maytreat additional
purchases and reductions in taxes as in-terchangeable near
equivalents, with the changes in thenet dierence between spending
and taxation identiedas the decit-nanced scal stimulus. The net
scal stim-ulus may be increased by raising spending above the
levelof tax revenues, reducing taxes below the level of govern-ment
spending, or any combination of the two that resultsin the
government taxing less than it spends.The extent of the multiplier
eect in increasing domesticbusiness activity is dependent upon the
marginal propen-sity to consume and marginal propensity to import.
Somepublic purchases or tax reductions may be identied ashaving
larger or more immediate eects on business ac-tivity in the
short-run. For example, it may be argued thattax cuts or spending
aimed at the lowest income house-holds, whose spending is most
constrained by income,will have a higher multiplier, because such
householdswill spend a larger fraction of any addition to
incomefaster.How potent a scal stimulus is in stimulating
expansionof economic activity may depend on how accommodat-ing the
monetary authoritythe central bankis. Manyeconomists subscribe to a
consensus view in which mone-tary policy is preferred as a means of
regulating the busi-
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3ness cycle, and scal stimulus is regarded as eective onlyin
circumstances in which monetary policy has becomeineective, because
policy interest rates are approachingthe zero lower bound or a
liquidity trap has developed,in which the nancial system is
hoarding money and fail-ing to nance risky investment in capital
formation andincreased output. If monetary policy was eective,
mon-etary policy would dominate scal policy, making the lat-ter
ineective. Additional public borrowing and spendingwould tend to
increase interest rates, because the mone-tary authority would
increase interest rates in responseto additional public borrowing
and spending, in an eortto contain the eects on the level of public
activitytoprevent overheating in the demand for resources and
in-ation, for example.Whether the long-run benets of public
investments inpublic goods and infrastructure, should be considered
inconstructing a quantied estimate of the multiplierthatis, whether
the multiplier should, in eect, incorporateor represent a
cost-benet analysisis an area of con-ceptual confusion and
controversy. In a case in whichthere appears to be substantial,
persistent unemployment,it can be argued that opportunity costs for
public spendingare reduced, to the extent that the multiplier
exceeds 1.Whether that would or should justify otherwise
wastefulgovernment spending is controversial, on the one hand,and
on the other hand, whether the supposed wastefulnessof government
spending justies reducing multiplier es-timates that reect only GDP
eects to smaller estimatesreecting welfare eects, remains a matter
of politicalcontroversy.It is sometimes argued that if the money is
borrowed,it must eventually be paid back with interest, such
thatthe long term eect on the economy depends on thetrade o between
the immediate increase to the GDP andthe long term cost of
servicing the resulting governmentdebt. This is a fallacy, insofar
as marketable governmentdebts are used by central banks as
instruments for mone-tary policy and by the nancial system as
instruments forhedging risk and portfolio management. The debts
maynever be paid back and even if they are paid back, itwill be in
purely nominal terms. The central bank is notcommitted to any
future course of policy by the issuingof public debt, and, in any
case, there would never be atradeo in which it would make sense to
reduce futureresource employment to pay back a debt. The capac-ity
to service the debt could only be enhanced by a futurepolicy of
full employment of national resources.The concept of the economic
multiplier on a macroeco-nomic scale can be extended to any
economic region. Forexample, building a new factory may lead to new
employ-ment for locals, which may have knock-on economic ef-fects
for the city or region.[6]
4 Various types of scalmultipliersThe following values are
theoretical values based on sim-plied models, and the empirical
values corresponding tothe reality have been found to be lower (see
below).Note: In the following examples the multiplier is
theright-hand-side equation without the rst component.
y is original output (GDP) bC is marginal propensity to consume
(MPC) bT is original income tax rate bM is marginal propensity to
import y is change in income (equivalent to GDP) aT is change in
lump-sum tax rate bT is change in income tax rate G is change in
government spending T is change in aggregate taxes I is change in
investment X is change in exports
4.1 Standard Income Tax Equationy = T bCy1bC(1bT )+bM
Note: only bT is here because if this is a change inincome tax
rate thenaT is implied to be 0.
4.2 Standard Government SpendingEquation
y = G 11 bC(1 bT ) + bM
4.3 Standard Investment Equation
y = I 11 bC(1 bT ) + bM
4.4 Standard Exports Equation
y = X 11 bC(1 bT ) + bM
4.5 Balanced-Budget Government Spend-ing Equation
y = G 1y = T 1
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4 6 CRITICISMS
5 Estimated values
5.1 United States of AmericaIn congressional testimony given in
July 2008, MarkZandi, chief economist for Moodys Economy.com,
pro-vided estimates of the one-year multiplier eect for sev-eral
scal policy options. The multipliers showed that anyform of
increased government spending would have moreof a multiplier eect
than any form of tax cuts. The mosteective policy, a temporary
increase in food stamps, hadan estimated multiplier of 1.73. The
lowest multiplierfor a spending increase was general aid to state
govern-ments, 1.36. Among tax cuts, multipliers ranged from1.29 for
a payroll tax holiday down to 0.27 for accel-erated depreciation.
Making the Bush tax cuts perma-nent had the second-lowest
multiplier, 0.29. Refundablelump-sum tax rebates, the policy used
in the EconomicStimulus Act of 2008, had the second-largest
multiplierfor a tax cut, 1.26.[7]
According to Otto Eckstein, estimation has found text-book
values of multipliers are overstated. The followingtables has
assumptions about monetary policy along theleft hand side. Along
the top is whether the multipliervalue is for a change in
government spending (G) or atax cut (T).The above table is for the
fourth quarter under which apermanent change in policy is in
force.[8]
In 2013 a study has been published examining economicfeatures
that impact scal multipliers. It found that theoutput eect of an
increase in government consumption islarger in industrial than in
developing countries, the scalmultiplier is relatively large in
economies operating underpredetermined exchange rate but zero in
economies op-erating under exible exchange rates; scal multipliers
inopen economies are lower than in closed economies andscal
multipliers in high-debt countries are also zero.[9]
5.2 EuropeItalian economists have estimated multiplier values
rang-ing from 1.4 up to 2.0 when dynamic eects are ac-counted for.
The economists used maa inuence as aninstrumental variable to help
estimate the eect of centralfunds given to local councils.[10]
5.3 IMFIn October 2012 the International Monetary Fund re-leased
their Global Prospects and Policies document inwhich an admission
was made that their assumptionsabout scal multipliers had been
inaccurate.
IMF sta reports, suggest that scal mul-tipliers used in the
forecasting process are
about 0.5. our results indicate that multi-pliers have actually
been in the 0.9 to 1.7range since the Great Recession. This nd-ing
is consistent with research suggesting thatin todays environment of
substantial economicslack, monetary policy constrained by the
zerolower bound, and synchronized scal adjust-ment across numerous
economies, multipliersmay be well above 1.[11]
This admission has serious implications for economiessuch as the
UK where the OBR used the IMFs assump-tions in their economic
forecasts about the consequencesof the governments austerity
policies.[12][13] It has beenconservatively estimated by the TUC
that the OBRs useof the IMFs under-estimated scal multiplication
valuesmeans that they may have under-estimated the economicdamage
caused by the UK governments austerity policiesby 76
billion.[14]
In their 2012 Forecast Evaluation Report the OBR ad-mitted that
underestimated scal multipliers could be re-sponsible for their
over-optimistic economic forecasts.
In trying to explain the unexpected weaknessof GDP growth over
this period, it is naturalto ask whether it was caused in part by
[scal]tightening either because it turned out to belarger than we
had originally assumed or be-cause a given tightening did more to
depressGDP than we had originally assumed.
In answering the question, we are concernedwith the aggregate
impact of dierent types ofscal tightening on GDP (measured using
so-called scal multipliers) and not simply thedirect contribution
that government investmentand consumption of goods and services
makesto the expenditure measure of GDP. This di-rect government
contribution has been morepositive for growth than we expected,
ratherthan more negative.[15]
6 Criticisms
6.1 Crowding out
It has been claimed that scal activity does not alwayslead to
increased economic activity because decit spend-ing used to nance
spending or tax cuts can crowd out -nancing for other economic
activity. This phenomenon isargued to be less likely to occur in a
recession, where sav-ings rates are traditionally higher and
capital is not beingfully utilized in the private market.[16]
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56.2 Marginal Propensity to Consume
As has been discussed, the Multiplier relies on the MPC(Marginal
Propensity to Consume). The use of the termMPC here, is a reference
to the MPC of a country (orsimilar economic unit) as a whole, and
the theory andthe mathematical formulae apply to this use of the
term.However, individuals have an MPC, and furthermoreMPC is not
homogeneous across society. Even if it was,the nature of the
consumption is not homogeneous. Someconsumption may be seen as more
benevolent (to theeconomy) than others. Therefore spending could be
tar-geted where it would do most benet, and thus generatethe
highest (closest to 1)MPC. This has traditionally beenregarded as
construction or other major projects (whichalso bring a direct
benet in the form of the nished prod-uct).Clearly, some sectors of
society are likely to have a muchhigher MPC than others. Someone
with above averagewealth or income or bothmay have a very low
(short term,at least) MPC of nearly zerosaving most of any
extraincome. But a pensioner, for example, will have an MPCof 1 or
even greater than 1. This is because a pensioneris quite likely to
spend every penny of any extra income.Further, if the extra income
is seen as regular extra in-come, and guaranteed into the future,
the pensioner mayactually spend MORE than the extra 1. This would
oc-cur where the extra income stream gives condence thatthe
individual does not need to put aside as much in theform of
savings, or perhaps can even dip into existing sav-ings.More
importantly, this consumption is much more likelyto occur in local
small businesslocal shops, pubs andother leisure activities for
example. These types of busi-nesses are themselves likely to have a
high MPC, andagain the nature of their consumption is likely to be
inthe same, or next tier of businesses, and also of a benev-olent
nature.Other individuals with a high, and benevolent, MPCwould
include almost anyone on a low incomestudents,parents with young
children, and the unemployed.
6.3 Externalities
It has also been argued that over-reliance upon scal
mul-tipliers can lead to the neglect of externalities such as
en-vironmental degradation, unsustainable resource deple-tion or
social consequences. Negative consequences ofover-reliance upon
scal multiplication values can eitherbe envisaged in increased
government spending on ac-tivities with high scal multiplication
values which cre-ate negative externalities (pollution, climate
change, re-source depletion, etc.) or through decreased spending
onactivities which create low immediate scal multiplica-tion values
but create positive externalities (educationalstandards, social
cohesion, public health, etc.).[17]
7 See also Complex multiplier Fiscal policy Keynesian economics
Local multiplier eect Transfer payments multiplier Multiplier
uncertainty
8 References[1] Snowdon, Brian; Vane, Howard R. (2005).
Modern
macroeconomics: its origins, development and currentstate.
Edward Elgar. p. 61. ISBN 978-1-84542-208-0.
[2] Coates, Dennis; Humphreys, Brad R. (October 27, 2004).Caught
Stealing: Debunking the Economic Case for D.C.Baseball. Cato
Insititute Brieng Papers (Cato Institute)(89). Retrieved
2011-10-10.
[3] Much ado about multipliers. The Economist. Sep 24,2009.
Retrieved 18 October 2011.
[4] A Labor Force Built to Last. United States Departmentof
Labor. Retrieved 21 February 2012.
[5] Rendahl, Pontus (26 April 2012). A case for balanced-budget
stimulus. VoxEU.org.
[6] http://www.choicesmagazine.org/2003-2/2003-2-06.htm
retrieved 27 September 2007.
[7] Zandi, Mark. A Second Quick Boost From GovernmentCould Spark
Recovery. Edited excerpts from congres-sional testimony July 24,
2008.
[8] Eckstein, Otto (1983). TheDRIModel of the US Economy.New
York: McGraw-Hill. ISBN 0-07-018972-2. Seealso Bodkin, Ronald G.;
Eckstein, Otto (1985). The DRIModel of the U. S. Economy. Southern
Economic Jour-nal 51 (4): 12531255. doi:10.2307/1058399.
JSTOR1058399.
[9] Ilzetzki, Ethan; Mendoza, Enrique G.; Vgh, CarlosA. (2013).
How Big (Small?) are Fiscal Multipli-ers?". Journal of Monetary
Economics 60 (2): 239254.doi:10.1016/j.jmoneco.2012.10.011.
[10] Acconcia, A.; Corsetti, G.; Simonelli, S. (2011). Maaand
Public Spending: Evidence on the Fiscal Multiplierfrom a Quasi
Experiment. CEPR Discussion Paper 8305.SSRN 1810270. See also
http://voxeu.org/index.php?q=node/6314.
[11] IMF Global Prospects and Policies report 2012, page 43
[12] Osbornes indiscriminate austerity
[13] Fiscal multipliers, the IMF and the OBR
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6 9 FURTHER READING
[14] George Osbornes austerity is costing UK an extra 76bn,says
IMF
[15] 2012 OBR Forecast Evaluation Report, page 53
[16] Woodford, Michael (2011). Simple Analytics of theGovernment
Expenditure Multiplier. American Eco-nomic Journal: Macroeconomics
3 (1): 135. JSTOR41237130.
[17] What is... scal multiplication
9 Further reading Dornbusch, Rdiger; Fischer, Stanley
(1990).
Macroeconomics (Fifth ed.). New York: McGraw-Hill. pp. 7890.
ISBN 0-07-017787-2.
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Net Government SpendingExamplesApplicationsVarious types of
fiscal multipliersStandard Income Tax EquationStandard Government
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EquationBalanced-Budget Government Spending Equation
Estimated valuesUnited States of AmericaEuropeIMF
CriticismsCrowding outMarginal Propensity to
ConsumeExternalities
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