The fiscal multiplier measures the effect that increases in fiscal spending will have on a nation’s economic output, or gross domestic product (GDP). Economists define fiscal multipliers as the ratio of a change in output to a change in tax revenue or government spending. Fiscal multipliers are crucial because they can guide a government’s policies during economic crises and set the stage for economic recovery.
Key Takeaways
- The fiscal multiplier measures the effect that increases in fiscal spending will have on a nation’s economic output or gross domestic product (GDP).
- At the core of fiscal multiplier theory lies the idea of marginal propensity to consume (MPC), which quantifies the increase in consumer spending, as opposed to saving, due to an increase in the income of an individual, household, or society.
- Evidence suggests that lower-income households have a higher MPC than do higher-income households.
Unpacking the Fiscal Multiplier
The fiscal multiplier is a concept rooted in Keynesian economics, first put forth by John Maynard Keynes’s student, Richard Kahn, in a 1931 paper. It depicts causality between changes in fiscal policy (the controlled variable) and GDP (the outcome). Central to fiscal multiplier theory is the marginal propensity to consume (MPC), which quantifies the increase in consumer spending resulting from an income rise in individuals, households, or society as a whole.
According to fiscal multiplier theory, if a country’s MPC is greater than zero, an initial influx of government spending will lead to a disproportionately larger increase in national income. The formula for the fiscal multiplier is:
(\text{Fiscal Multiplier} = \frac{1}{1 - \text{MPC}})
Where:
- MPC: Marginal propensity to consume
Real-World Example of the Fiscal Multiplier
Imagine a national government implements a $1 billion fiscal stimulus, and the MPC among consumers is 0.75. The initial $1 billion will lead to consumers saving $250 million and spending $750 million, thus igniting additional spending rounds. The recipients of that $750 million will spend $562.5 million, and so forth.
The total change in national income is the initial increase in government, or “autonomous,” spending times the fiscal multiplier. With an MPC of 0.75, the fiscal multiplier would be four. This means Keynesian theory would predict an overall boost to the national income of $4 billion from the original $1 billion fiscal stimulus.
Economists use other multipliers besides the fiscal multiplier, such as the earnings multiplier and the investment multiplier, to analyze economic behaviors.
The Fiscal Multiplier in Action
Empirical evidence indicates that the relationship between spending and economic growth is complex. Factors like differing MPCs among societal segments and the form in which the fiscal stimulus is delivered can affect fiscal multipliers. For example, lower-income households are more likely to spend additional income than higher-income households.
In 2009, Mark Zandi, then chief economist of Moody’s, estimated fiscal multipliers for several policy options based on a one-year dollar increase in real GDP per dollar of spending or decrease in federal tax revenue:
| Policy Option | Fiscal Multiplier |
|---|---|
| Tax cuts | |
| Nonrefundable lump-sum tax rebate | 1.01 |
| Refundable lump-sum tax rebate | 1.22 |
| Temporary tax cuts | |
| Payroll tax holiday | 1.29 |
| Across-the-board tax cut | 1.02 |
| Accelerated depreciation | 0.25 |
| Permanent tax cuts | |
| Extend alternative minimum tax patch | 0.51 |
| Make Bush income tax cuts permanent | 0.32 |
| Make dividend and capital gains tax cuts permanent | 0.37 |
| Cut corporate tax rate | 0.32 |
| Spending increases | |
| Extend unemployment insurance benefits | 1.61 |
| Temporarily increase food stamps | 1.74 |
| Temporary federal financing of work-share programs | 1.69 |
| Issue general aid to state governments | 1.41 |
| Increase infrastructure spending | 1.57 |
Policies increasing food stamps, financing work-share programs, and extending unemployment benefits are cited as highly effective, primarily because they target low-income groups with high marginal propensities to consume.
Special Considerations
The prominence of the fiscal multiplier in policymaking has fluctuated over the decades. Although fundamental in the 1960s, its credibility took a hit during the stagflation era of the 1970s. Many policymakers turned to monetarist approaches, stressing money supply regulation over government spending.
Yet, the 2008 financial crisis saw a revival of the fiscal multiplier’s significance. Countries like the U.S., which invested heavily in fiscal stimulus, observed faster and more stable recoveries compared to regions like Europe, which leaned towards fiscal austerity.
Related Terms: economic stimulus, gross domestic product (GDP), marginal propensity to consume (MPC), economic recovery, Keynesian Economics.
References
- R.F. Kahn. “The Relation of Home Investment to Unemployment”. The Economic Journal, Vol. 41, No. 162, June 1931.
- Mark Zandi. “The Impact of the Recovery Act on Economic Growth”. Page 3.
