Fiscal multipliers

Fiscal multipliers relate to the impact of a change in a fiscal deficit (ΔG or – ΔT) on real national output¹.

Hence they show the impact of a discretionary increase or decrease in government spending or taxation, and can be measured in several ways.

The fiscal expenditure multiplier is expressed as:

The fiscal revenue multiplier is expressed as:

(¹see Spilimbergo, A., S. Symansky, and M. Schindler, 2009)

The importance of fiscal multipliers

Fiscal policy is commonly used to help ‘smooth’ demand following an economic shock. It is important for a government to have an accurate assessment of the size of these multipliers at various times and under different circumstances so that any injection or withdrawal of demand through a fiscal instrument can help achieved a specific desired objective for that instrument.

For example, over-estimating the size of these fiscal multipliers might mean that the policy change is too weak to achieve the desired objective, whereas under-estimating the size of the fiscal multiplier might mean that the government injects too much demand into the economy, creating inflationary pressure.

The value of fiscal multipliers

Estimates of the value of fiscal multipliers vary widely – partly because of the use of different modelling methods (see Spilimbergo et al, 2009), and because even a single modelling method will give different results at different times, under different economic circumstances, and using different assumptions. Estimates tend to vary between values of 0.5 and 2.5, with most estimates suggesting that fiscal expenditure multipliers are larger than revenue multipliers.

Economists (see Spilimbergo et al, 2009) commonly differentiate different types of fiscal multiplier, including:

1. The short-run impact multiplier, which is usually defined as the multiplier in the first quarter following the change in tax or spending;

1. The multiplier at an horizon which is relates to the effect of the tax or spending change on GDP after a period of time, such as 2 years after the policy change.

1. The peak multiplier, which is the largest value it will rise to, over the ‘horizon’, and;

The cumulative multiplier, which is accumulated change in output over the ‘horizon’.

It is common to assume that fiscal multipliers are a positive value – i.e. a £1 increase in government spending leading to an increase in GDP. However, it is highly possible that the fiscal multiplier will be negative, especially if an increase in borrowing to fund government spending has a negative impact on consumer and business confidence.

Factors affecting the size of fiscal multipliers

Structural factors

Structural factors are those that influence the size of fiscal multipliers under ‘normal’ economic circumstances – that is, not in a period of extreme economic disturbance, such as a financial crisis or an oil shock. These factors include:

Trade openness

The size of the fiscal multiplier is influenced by the relative size of imports. Some of the increase in demand resulting from a fiscal stimulus will leak abroad, meaning that the value of demand circulating around the domestic economy will be relatively smaller when the marginal propensity to import is higher.

Taking a wider view, increased globalisation has reduced the size of fiscal multipliers across the global economy, and potentially reduced the effectiveness of fiscal policy.

The exchange rate regime

When exchange rates are flexible, the fiscal multipliers may be small given that any change in taxes or spending may result in adjustments in the exchange rate which can nullify the final effect on national output.

For example, an increase in government spending designed to increase aggregate demand may weaken the exchange rate, which in the short run, may increase import prices, and import spending – hence the injection of government spending is nullified by the leakage in spending resulting from higher import spending.

The level of debt

In general, debt levels affect the size of fiscal multipliers, with high debt levels, such as those found in heavily indebted countries, reducing the value of fiscal multipliers. Debt is clearly a burden on an economy, and injections of new government spending may simply work its way through the economy to service debt rather than generate new output. The higher the level of debt, the lower the multiplier, and indeed research indicates that when debt levels reach over 90% of GDP, fiscal multipliers may become negative! (see Ilzetzki et al. 2010).

The impact of automatic stabilisers

When automatic stabilisers are large, fiscal multipliers will tend to be smaller. Automatic stabilisers nullify the impact of any economic shock on aggregate demand. For example, assuming the government provides a fiscal boost to the economy, the combined automatic response of welfare benefits, which will decline as unemployment falls, and tax payments, which will rise as spending across the economy increases, will offset part of the initial fiscal stimulus. Added together, falling benefits and rising tax payments nullify the impact of the fiscal boost, hence lowering the fiscal multipliers.

Labour market flexibility

A more flexible and deregulated labour market will tend to reduce the size of the fiscal multipliers. For example, part of the effect of a fiscal stimulus, which may increase labour market participation, may go back to the government in higher tax revenues, hence reducing the final impact of the stimulus on GDP.

Temporary factors

The size of fiscal multipliers will also be affected by short term factors, such as:

Changes in the business cycle

Extensive research, summarised in a paper by the IMF (2014), suggests that fiscal multipliers are much larger when an economy is experiencing a downturn and smaller when in an upturn. In an upturn it is suggested that, as the economy approaches full capacity, some crowding out occurs when, for example, discretionary government spending increases. This results from a fall in the elasticity of supply of factors of production as full capacity approaches. Hence, the argument goes, in an upturn every pound spent by government results in less private spending, either via lower investment or lower consumer spending. In a downturn, however, excess capacity exists, and crowding out will be much lower, or even non-existent.

The impact of monetary policy

Changes in monetary policy can alter the size of fiscal multipliers. For example, if monetary policy is loosened while at the same time there is a fiscal contraction, the fiscal multiplier will be lower than without the monetary expansion. If monetary policy is rigid, then the fiscal multipliers will be larger.

Fiscal multipliers