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

Economists' views about the size of the fiscal multiplier have usually been associated with their opinions about Keynesian economics - a subject on which they differ widely. The post-war consensus in favour of discretionary fiscal policy was associated with an implied assumption of a multiplier substantially above one, but the subsequent consensus in favour of the use of monetary policy implicitly assumed a fractional or negligible fiscal multiplier. When discretionary fiscal policy found favour again following the crash of 2008 (with the prospect of a recession too deep to be managed, even by reducing the short-term interest rate to its zero bound), Christine Romer (chair of his Council of Economic Advisors) advised President Obama that the fiscal stimulus then proposed would have a multiplier of about 1.6. That advice was contested at the time by Professor Barro, who argued on a priori grounds that the value would be near zero. A series of academic papers published some two years previously provided estimates in the range 1 to 1.5, and Barry Eichengreen has derived an estimate of 1.6 from study of 27 countries in the 1930s (the last time when interest rates were at or near zero)