Fiscal multiplier

The fiscal multiplier is the factor which relates an increase or decrease in real GDP, to the decrease or increase in the country's budget balance, that causes it.

Theoretical background

The multiplier effect model is an extension of the basic spending multiplier model that relaxes the simplifying assumptions of that model. In doing so, it extends an identity, that was concerned with the multiplicative effect of circular monetary flows, to create a relationship between a monetary injection and the consequent change in real (inflation-corrected) GDP. The outcome, though still termed "the multiplier", is a factor that is not necessarily greater than one, and whose value is dependent upon a range of behavioural and environmental influences. Theoretical considerations suggest that the size of the multiplier is influenced by an economy's exchange rate regime, its openness to trade, the effectiveness of its monetary policy, the degree of access to credit, and the states of consumer and investor expectations. Its magnitude may be expected to depend critically upon the amount of unused capacity in an economy, and it is expected to be larger than average when the economy is in recession. Available theory provides little guidance as to the relative magnitude of those influences, however.

Applications

The fiscal multiplier is not just a component of economic forecasting models: it is also one of the determinants of fiscal policy. It determines the size of the fiscal stimulus necessary to counter a given recession. It determines the extent to which the benefits of fiscal consolidation are offset by reductions in output and employment. Also, by allowing for the resulting falls in tax revenue and rises in welfare payments, it can set a limit upon the rate of fiscal consolidation above which it would cause an increase - rather than the intended reduction - in the level of public debt.

Estimates

<!- Former presidential advisor Christine Romer has argued that that it is "incredibly hard" to estimate the value of a multiplier because fiscal actions are often taken in response to other things happening in the economy, and separating the impact of those other factors from the impact of the tax changes or spending decisions is very difficult.

Ridiculed on mainly a priori grounds

Based on a study of 27 countries in the 1930s (the last time when interest rates were at or near zero) Barry Eichengreen and his colleagues estimate a value of 1.6