In economics, the fiscal multiplier (not to be confused with the money multiplier) is the ratio of change in national income arising from a change in government spending. More generally, the exogenous spending multiplier is the ratio of change in national income arising from any autonomous change in spending (including private investment spending, consumer spending, government spending, or spending by foreigners on the country's exports). When this multiplier exceeds one, the enhanced effect on national income may be called the multiplier effect. The mechanism that can give rise to a multiplier effect is that an initial incremental amount of spending can lead to increased income and hence increased consumption spending, increasing income further and hence further increasing consumption, etc., resulting in an overall increase in national income greater than the initial incremental amount of spending. In other words, an initial change in aggregate demand may cause a change in aggregate output (and hence the aggregate income that it generates) that is a multiple of the initial change.

The existence of a multiplier effect was initially proposed by Keynes' student Richard Kahn in 1930 and published in 1931.^[1] Some other schools of economic thought reject or downplay the importance of multiplier effects, particularly in terms of the long run. The multiplier effect has been used as an argument for the efficacy of government spending or taxation relief to stimulate aggregate demand.

In certain cases multiplier values less than one have been empirically measured (an example is sports stadiums), suggesting that certain types of government spending crowd out private investment or consumer spending that would have otherwise taken place. This crowding out can occur because the initial increase in spending may cause an increase in interest rates or in the price level.^[2] In 2009, The Economist magazine noted "economists are in fact deeply divided about how well, or indeed whether, such stimulus works",^[3] partly because of a lack of empirical data from non-military based stimulus. New evidence came from the American Recovery and Reinvestment Act of 2009, whose benefits were projected based on fiscal multipliers and which was in fact followed—from 2010 to 2012—by a slowing of job loss and job growth in the private sector.^[4]

Net government spending

The other important aspect of the multiplier is that to the extent that government spending generates new consumption, it also generates "new" tax revenues. For example, when money is spent in a shop, purchases taxes such as VAT are paid on the expenditure, and the shopkeeper earns a higher income, and thus pays more income taxes. Therefore, although the government spends $1, it is likely that it receives back some proportion of the $1 in due course, making the net expenditure less than $1.

Where the government spending is in the form of wages and salaries, there will be an almost immediate recouping of an amount of income tax and other forms of income taxation (such as National Insurance in the UK). This is also true to some extent with spending on pensions and benefits.

Example

For example, suppose that a government spends $1 million to have a factory built. The money does not disappear, but rather becomes wages to builders, revenue to suppliers etc. The builders will have higher disposable income, and consumption may rise, so that aggregate demand will also rise. Supposing further that recipients of the new spending by the government in turn spend their new income, this will raise demand and possibly consumption further, and so on.

The increase in the gross domestic product is the sum of the increases in net income of everyone affected. If the builder receives $1 million and pays out $800,000 to sub-contractors, he has a net income of $200,000 and a corresponding increase in disposable income (the amount remaining after taxes).

This process proceeds down the line through sub-contractors and their employees, each experiencing an increase in disposable income to the degree the new work they perform does not displace other work they are already performing. Each participant who experiences an increase in disposable income then spends some portion of it on final (consumer) goods, according to his or her marginal propensity to consume, which causes the cycle to repeat an arbitrary number of times, limited only by the spare capacity available.

Applications

The multiplier effect is exploited by governments attempting to use fiscal stimulus policies to increase the general level of economic activity. This can be done in a period of recession or economic uncertainty, when unemployment of labor is high and other resources are underutilized. Increased spending by government increases the rate of aggregate demand, increasing business activity, which increases income, which further increases spending and aggregate demand, in a virtuous cycle. The idea is that the total increase in production and income by all parties throughout the economy may be greater than the original increment to government spending, as additional resources are drawn into the circular flows of money spending and business activity through the economy. The existence of idle capacity and involuntary unemployment of labor in the economy can be represented as an output gap—a difference between actual GDP and potential GDP—and a policy of fiscal stimulus may aim at introducing sufficient additional spending, amplified by the multiplier, to speed the closing of the output gap.

Any additional spending by government must be financed, by drawing down reserves, by additional taxes or by issuing additional government debt instruments (i.e. borrowing). Increased taxes exactly matched to increased spending might seem designed to draw out of the circulating flow of the economy an amount of income in taxes exactly equal to the amount being injected by additional government purchases. Increased borrowing to finance additional government purchases might also be supposed to be designed to draw out of the circulating flow an amount equal to the additional government purchases, perhaps by crowding out private borrowing for investment spending. In the history of economic thought, the notion that any increase in government spending necessarily crowds out an equal amount of private spending or investment, through taxation or borrowing, and thus has no net impact on economic activity, is known as the Treasury View, and is regarded as generally fallacious. The argument that the choice of taxes or borrowing to finance government spending must be equivalent in that taxpayers observe borrowing and save in anticipation of taxes to repay the borrowing is known as Ricardian Equivalence, and is sometimes cited as a rationale for believing that fiscal stimulus policy will be made futile by the reactions of rational consumers and businesses, reducing their spending or investing in exact proportion to increases in public spending, in a scenario similar to that envisioned in the Treasury View.

Whether an incremental increase to government spending will have a multiplier effect is thought to depend on circumstances in the economy: first, particularly on the extent to which unemployment of resources may be high, so that the additional demand represented by government purchases may be realized by additional production and higher utilization of resources, without bidding up prices; second, by the state of the financial and credit markets, where demand for money and money instruments may welcome additional government debt as low-risk securities, but may regard investment in private production capacity or capital formation as too risky, given a low level of general business activity.

When unemployment of resources in the economy is high, and cash, in effect, is being hoarded in the financial and credit system, the fiscal multiplier may be 1 or greater. Even a balanced budget fiscal stimulus—additional public purchases fully financed by equivalent increases in taxation without any additional public borrowing—may have a multiplier greater than 1, as the increase in output and business activity reduces persistent unemployment and the anxiety driving hoarding, with resulting increases in private consumption and investment reducing the time it takes for the economy to return to full employment.^[5]

Government borrowing to finance additional public purchases in circumstances in which cash is being hoarded in the financial and credit system will not displace private investment spending. An additional supply of low-risk government securities may simply provide vehicles for continued hoarding as short-term government securities are regarded as closely equivalent to cash. In such circumstances, policy to increase aggregate demand and total business activity by means of fiscal measures may treat additional purchases and reductions in taxes as interchangeable near equivalents, with the changes in the net difference between spending and taxation identified as the deficit-financed fiscal stimulus. The net fiscal stimulus may be increased by raising spending above the level of tax revenues, reducing taxes below the level of government spending, or any combination of the two that results in the government taxing less than it spends.

The extent of the multiplier effect in increasing domestic business activity is dependent upon the marginal propensity to consume and marginal propensity to import. Some public purchases or tax reductions may be identified as having larger or more immediate effects on business activity in the short-run. For example, it may be argued that tax cuts or spending aimed at the lowest income households, whose spending is most constrained by income, will have a higher multiplier, because such households will spend a larger fraction of any addition to income faster.

How potent a fiscal stimulus is in stimulating expansion of economic activity may depend on how accommodating the monetary authority—the central bank—is. Many economists subscribe to a consensus view in which monetary policy is preferred as a means of regulating the business cycle, and fiscal stimulus is regarded as effective only in circumstances in which monetary policy has become ineffective, because policy interest rates are approaching the zero lower bound or a liquidity trap has developed, in which the financial system is hoarding money and failing to finance risky investment in capital formation and increased output. If monetary policy was effective, monetary policy would dominate fiscal policy, making the latter ineffective. Additional public borrowing and spending would tend to increase interest rates, because the monetary authority would increase interest rates in response to additional public borrowing and spending, in an effort to contain the effects on the level of public activity—to prevent overheating in the demand for resources and inflation, for example.

Whether the long-run benefits of public investments in public goods and infrastructure, should be considered in constructing a quantified estimate of the multiplier—that is, whether the multiplier should, in effect, incorporate or represent a cost-benefit analysis—is an area of conceptual confusion and controversy. In a case in which there appears to be substantial, persistent unemployment, it can be argued that opportunity costs for public spending are reduced, to the extent that the multiplier exceeds 1. Whether that would or should justify otherwise wasteful government spending is controversial, on the one hand, and on the other hand, whether the supposed wastefulness of government spending justifies reducing multiplier estimates that reflect only GDP effects to smaller estimates reflecting welfare effects, remains a matter of political controversy.

It is sometimes argued that if the money is borrowed, it must eventually be paid back with interest, such that the long-term effect on the economy depends on the trade off between the immediate increase to the GDP and the long-term cost of servicing the resulting government debt. This is a fallacy, insofar as marketable government debts are used by central banks as instruments for monetary policy and by the financial system as instruments for hedging risk and portfolio management. The debts may never be "paid back" and even if they are paid back, it will be in purely nominal terms. The central bank is not committed to any future course of policy by the issuing of public debt, and, in any case, there would never be a "tradeoff" in which it would make sense to reduce future resource employment to "pay back" a debt. The capacity to service the debt could only be enhanced by a future policy of full employment of national resources.

The concept of the economic multiplier on a macroeconomic scale can be extended to any economic region. For example, building a new factory may lead to new employment for locals, which may have knock-on economic effects for the city or region.^[6]

Fiscal multipliers in simplified context

The following values are theoretical values based on simplified models that assume, for example, no changes in interest rates or the price level resulting from the fiscal action. The empirical values corresponding to the reality have been found to be lower (see below).

In the following examples the multiplier is the right-hand-side of the equation without the first component.

• y is original output (GDP)
• ${\displaystyle b_{C}}$ is marginal propensity to consume (MPC)
• ${\displaystyle b_{T}}$ is original income tax rate
• ${\displaystyle b_{M}}$ is marginal propensity to import (MPI)
• ${\displaystyle \Delta y}$ is change in income (equivalent to GDP)
• ${\displaystyle \Delta G}$ is change in government spending
• ${\displaystyle \Delta T}$ is change in aggregate taxes

Estimated values

Criticisms

See also

• Complex multiplier
• Fiscal policy
• Input–output model
• Keynesian economics
• Local multiplier effect
• Transfer payments multiplier
• Multiplier uncertainty

References

Further reading

• Dornbusch, Rüdiger; Fischer, Stanley (1990). Macroeconomics (Fifth ed.). New York: McGraw-Hill. pp. 78–90. ISBN 0-07-017787-2.
• Nakamura, Emi, and Jón Steinsson. 2018. "Identification in Macroeconomics." Journal of Economic Perspectives, 32 (3): 59-86.