What Is the Fiscal Multiplier?

What Is the Fiscal Multiplier?

Let me explain the fiscal multiplier directly: it measures how increases in government spending affect a nation's economic output, specifically its gross domestic product (GDP). Economists define it as the ratio of a change in output to a change in tax revenue or government spending. You should know that fiscal multipliers are crucial because they guide government policies during economic crises and set the foundation for recovery.

Key Takeaways

The fiscal multiplier directly shows the effect of boosted fiscal spending on GDP. Central to this is the marginal propensity to consume (MPC), which measures how much more people spend rather than save when their income rises—for an individual, household, or society. Evidence indicates that lower-income households have a higher MPC compared to those with higher incomes.

Understanding the Fiscal Multiplier

This is a Keynesian concept, first outlined by Richard Kahn, a student of John Maynard Keynes, in a 1931 paper. It's presented as a ratio linking changes in fiscal policy to GDP outcomes. The theory revolves around MPC, quantifying the spending increase from added income.

The idea is that if a country's overall MPC exceeds zero, an initial government spending injection will produce a larger rise in national income. The fiscal multiplier reveals how much greater—or smaller, if counterproductive—the gain in national income is relative to the extra spending. Here's the formula: Fiscal Multiplier = 1 / (1 - MPC), where MPC is the marginal propensity to consume.

Example of the Fiscal Multiplier

Consider this scenario: a government implements a $1 billion fiscal stimulus with consumers having an MPC of 0.75. Those receiving the initial $1 billion save $250 million and spend $750 million, sparking another stimulus round. Recipients of that $750 million then spend $562.5 million, and this continues.

The total national income change equals the initial autonomous spending times the fiscal multiplier. With MPC at 0.75, the multiplier is 4, so Keynesian theory predicts a $4 billion boost to national income from the $1 billion stimulus.

Important Note on Other Multipliers

Beyond the fiscal multiplier, economists examine others like the earnings multiplier and investment multiplier to analyze economic behavior.

The Fiscal Multiplier in the Real World

Real-world evidence shows the spending-growth relationship is more complex than theory suggests. Not everyone has the same MPC; lower-income households spend more of a windfall than higher-income ones. MPC also varies by how stimulus is delivered, leading to different multipliers for policies.

In 2009, Mark Zandi of Moody's estimated multipliers for options, showing one-year real GDP increases per dollar of spending or tax cut.

Analysis of Effective Policies

The most effective are temporarily increasing food stamps (1.74), work-share financing (1.69), and extending unemployment benefits (1.61). These target low-income groups with high MPC. In contrast, permanent tax cuts for higher-income households have multipliers below 1, adding only cents to GDP per dollar forgone in revenue.

Special Considerations

The fiscal multiplier's policy influence has fluctuated. Keynesian ideas dominated in the 1960s, but stagflation in the 1970s eroded faith, shifting favor to monetarist approaches like money supply regulation. Post-2008 crisis, it regained traction; the U.S. used heavy fiscal stimulus for a strong recovery.

What Is the Difference Between the Fiscal Multiplier and the Money Multiplier?

The fiscal multiplier examines how government spending boosts the economy, while the money multiplier looks at money supply changes' effects on output.

Why Is the Fiscal Multiplier Less Than 1?

In normal times, without booms or busts, it's often below 1 because financing increased spending creates a negative wealth effect, and it can lead to inflation and higher interest rates that offset gains.

Can a Fiscal Multiplier Be Negative?

Yes, it can be negative, meaning spending increases reduce GDP, such as when they crowd out private activity or signal future fiscal tightening amid high debt.

The Bottom Line

The fiscal multiplier evaluates government spending's GDP impact, based on people spending more with higher income. Policy effectiveness varies, but targeting low-income groups boosts the economy most. It's particularly useful for economic recovery.