Fiscal multiplier

This article is about the eect of spending on national 1 Net Government Spending
income. For the multiplier eect in banking, see
Fractional-reserve banking.
The other important aspect of the multiplier is that to the
extent that government spending generates new consumpIn economics, the scal multiplier (not to be confused tion, it also generates new tax revenues. For example,
with monetary multiplier) is the ratio of a change in when money is spent in a shop, purchases taxes such as
national income to the change in government spending VAT are paid on the expenditure, and the shopkeeper
that causes it. More generally, the exogenous spending earns a higher income, and thus pays more income taxes.
multiplier is the ratio of a change in national income Therefore, although the government spends $1, it is likely
to any autonomous change in spending (private invest- that it receives back a signicant proportion of the $1 in
ment spending, consumer spending, government spend- due course, making the net expenditure much less than
ing, or spending by foreigners on the countrys exports) $1. Indeed, in theory, it is possible, if the initial expenthat causes it. When this multiplier exceeds one, the diture is targeted well, that the government could receive
enhanced eect on national income is called the mul- back more than the initial $1 expended.
tiplier eect. The mechanism that can give rise to a
multiplier eect is that an initial incremental amount of
spending can lead to increased consumption spending,
2 Examples
increasing income further and hence further increasing
consumption, etc., resulting in an overall increase in national income greater than the initial incremental amount For example: a company spends $1 million to build a
of spending. In other words, an initial change in aggregate factory. The money does not disappear, but rather bedemand may cause a change in aggregate output (and comes wages to builders, revenue to suppliers etc. The
hence the aggregate income that it generates) that is a builders will have higher disposable income, and consumption may rise, so that aggregate demand will also
multiple of the initial change.
rise. Suppose further that recipients of the new spending
The existence of a multiplier eect was initially proposed
by the builder in turn spend their new income, this will
by Keynes student Richard Kahn in 1930 and published in
raise demand and possibly consumption further, and so
1931.[1] Some other schools of economic thought reject
on.
or downplay the importance of multiplier eects, particularly in terms of the long run. The multiplier eect The increase in the gross domestic product is the sum of
has been used as an argument for the ecacy of govern- the increases in net income of everyone aected. If the
ment spending or taxation relief to stimulate aggregate builder receives $1 million and pays out $800,000 to sub
contractors, he has a net income of $200,000 and a corredemand.
sponding increase in disposable income (the amount reIn certain cases multiplier values less than one have been
maining after taxes).
empirically measured (an example is sports stadiums),
suggesting that certain types of government spending This process proceeds down the line through subcontraccrowd out private investment or consumer spending that tors and their employees, each experiencing an increase
would have otherwise taken place. This crowding out in disposable income to the degree the new work they percan occur because the initial increase in spending may form does not displace other work they are already percause an increase in interest rates or in the price level.[2] forming. Each participant who experiences an increase
In 2009, because of the use of scal multipliers to project in disposable income then spends some portion of it on
the benets of the American Recovery and Reinvestment nal (consumer) goods, according to his or her marginal
Act of 2009, The Economist magazine noted economists propensity to consume, which causes the cycle to repeat
are in fact deeply divided about how well, or indeed an arbitrary number of times, limited only by the spare
whether, such stimulus works[3] due to a lack of empir- capacity available.
ical data from non-military based stimulus. Immediately Another example: when tourists visit somewhere they
after the stimulus bill took eect, job loss slowed and need to buy the plane ticket, catch a taxi from the airport
private sector job growth resumed in 2010 and has con- to the hotel, book in at the hotel, eat at the restaurant and
tinued through 2012.[4]
go to the movies or tourist destination. The taxi driver
needs petrol (gasoline) for his cab, the hotel needs to hire
1

3 APPLICATIONS

the sta, the restaurant needs attendants and chefs, and circumstances in the economy: rst, particularly on the
the movies and tourist destinations need sta and clean- extent to which unemployment of resources may be high,
ers.
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 nancial and credit markets,
3 Applications
where demand for money and money instruments may
welcome additional government debt as low-risk securiThe multiplier eect is exploited by governments at- ties, but may regard investment in private production catempting to use scal stimulus policies to increase the pacity or capital formation as too risky, given a low level
general level of economic activity. This can be done in a of general business activity.
period of recession or economic uncertainty, when unemployment of labor is high and other resources are under- When unemployment of resources in the economy is
utilized. Increased spending by government increases the high, and cash, in eect, is being hoarded in the rate of aggregate demand, increasing business activity, nancial and credit system, the scal multiplier may be
which increases income, which further increases spend- 1 or greater. Even a balanced budget scal stimulus
ing and aggregate demand, in a virtuous cycle. The idea is additional public purchases fully nanced by equivathat the total increase in production and income by all par- lent increases in taxation without any additional public
ties throughout the economy may be greater than the orig- borrowingmay have a multiplier greater than 1, as the
inal increment to government spending, as additional re- increase in output and business activity reduces persistent
sources are drawn into the circular ows of money spend- unemployment and the anxiety driving hoarding, with reing and business activity through the economy. The ex- sulting increases in private consumption and investment
istence of idle capacity and involuntary unemployment reducing the time[5]it takes for the economy to return to
of labor in the economy can be represented as an out- full employment.
put gapa dierence between actual GDP and poten- Government borrowing to nance additional public purtial GDPand a policy of scal stimulus may aim at in- chases in circumstances in which cash is being hoarded
troducing sucient additional spending, amplied by the in the nancial and credit system will not displace primultiplier, to speed the closing of the output gap.
vate investment spending. An additional supply of lowAny additional spending by government must be - risk government securities may simply provide vehicles
nanced, by drawing down reserves, by additional taxes for continued hoarding as short-term government secuor by issuing additional government debt instruments (i.e. rities are regarded as closely equivalent to cash. In such
borrowing). Increased taxes exactly matched to increased circumstances, policy to increase aggregate demand and
spending might seem designed to draw out of the cir- total business activity by means of scal measures may
culating ow of the economy an amount of income in treat additional purchases and reductions in taxes as intaxes exactly equal to the amount being injected by ad- terchangeable near equivalents, with the changes in the
ditional government purchases. Increased borrowing to net dierence between spending and taxation identied
nance additional government purchases might also be as the decit-nanced scal stimulus. The net scal stimsupposed to be designed to draw out of the circulating ulus may be increased by raising spending above the level
ow an amount equal to the additional government pur- of tax revenues, reducing taxes below the level of governchases, perhaps by crowding out private borrowing for in- ment spending, or any combination of the two that results
vestment spending. In the history of economic thought, in the government taxing less than it spends.
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
nance 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 scal 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.

The extent of the multiplier eect 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 identied as
having larger or more immediate eects 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 scal stimulus is in stimulating expansion

of economic activity may depend on how accommodating the monetary authoritythe central bankis. Many
economists subscribe to a consensus view in which moneWhether an incremental increase to government spend- tary policy is preferred as a means of regulating the busiing will have a multiplier eect is thought to depend on

3
ness cycle, and scal stimulus is regarded as eective only
in circumstances in which monetary policy has become
ineective, because policy interest rates are approaching
the zero lower bound or a liquidity trap has developed,
in which the nancial system is hoarding money and failing to nance risky investment in capital formation and
increased output. If monetary policy was eective, monetary policy would dominate scal policy, making the latter ineective. 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 eort
to contain the eects on the level of public activityto
prevent overheating in the demand for resources and ination, for example.

4 Various types of scal multipliers

The following values are theoretical values based on simplied models, and the empirical values corresponding to
the reality have been found to be lower (see below).
Note: In the following examples the multiplier is the
right-hand-side equation without the rst component.
y is original output (GDP)
bC is marginal propensity to consume (MPC)
bT is original income tax rate
bM is marginal propensity to import

y is change in income (equivalent to GDP)

Whether the long-run benets of public investments in
public goods and infrastructure, should be considered in
aT is change in lump-sum tax rate
constructing a quantied estimate of the multiplierthat
bT is change in income tax rate
is, whether the multiplier should, in eect, incorporate
or represent a cost-benet analysisis an area of con G is change in government spending
ceptual confusion and controversy. In a case in which
there appears to be substantial, persistent unemployment,
T is change in aggregate taxes
it can be argued that opportunity costs for public spending
I is change in investment
are reduced, to the extent that the multiplier exceeds 1.
Whether that would or should justify otherwise wasteful
X is change in exports
government spending is controversial, on the one hand,
and on the other hand, whether the supposed wastefulness
of government spending justies reducing multiplier es- 4.1 Standard Income Tax Equation
timates that reect only GDP eects to smaller estimates
C y
y = T 1bC b
reecting welfare eects, remains a matter of political
(1bT )+bM
controversy.
It is sometimes argued that if the money is borrowed, Note: only bT is here because if this is a change in
it must eventually be paid back with interest, such that income tax rate then aT is implied to be 0.
the long term eect on the economy depends on the
trade o 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 nancial 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
tradeo 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.

4.2 Standard
Equation
y = G

Government

Spending

1
1 bC (1 bT ) + bM

4.3 Standard Investment Equation

y = I

1
1 bC (1 bT ) + bM

4.4 Standard Exports Equation

The concept of the economic multiplier on a macroeco1

nomic scale can be extended to any economic region. For y = X 1 bC (1 bT ) + bM
example, building a new factory may lead to new employment for locals, which may have knock-on economic ef4.5 Balanced-Budget Government Spendfects for the city or region.[6]

ing Equation

y = G 1
y = T 1

5
5.1

Estimated values
United States of America

In congressional testimony given in July 2008, Mark

Zandi, chief economist for Moodys Economy.com, provided estimates of the one-year multiplier eect for several scal policy options. The multipliers showed that any
form of increased government spending would have more
of a multiplier eect than any form of tax cuts. The most
eective policy, a temporary increase in food stamps, had
an estimated multiplier of 1.73. The lowest multiplier
for a spending increase was general aid to state governments, 1.36. Among tax cuts, multipliers ranged from
1.29 for a payroll tax holiday down to 0.27 for accelerated depreciation. Making the Bush tax cuts permanent had the second-lowest multiplier, 0.29. Refundable
lump-sum tax rebates, the policy used in the Economic
Stimulus Act of 2008, had the second-largest multiplier
for a tax cut, 1.26.[7]

CRITICISMS

about 0.5. our results indicate that multipliers have actually been in the 0.9 to 1.7
range since the Great Recession. This nding is consistent with research suggesting that
in todays environment of substantial economic
slack, monetary policy constrained by the zero
lower bound, and synchronized scal adjustment across numerous economies, multipliers
may be well above 1.[11]

This admission has serious implications for economies

such as the UK where the OBR used the IMFs assumptions in their economic forecasts about the consequences
of the governments austerity policies.[12][13] It has been
conservatively estimated by the TUC that the OBRs use
of the IMFs under-estimated scal multiplication values
means that they may have under-estimated the economic
damage caused by the UK governments austerity policies
by 76 billion.[14]

In their 2012 Forecast Evaluation Report the OBR adAccording to Otto Eckstein, estimation has found textmitted that underestimated scal multipliers could be rebook values of multipliers are overstated. The following
sponsible for their over-optimistic economic forecasts.
tables has assumptions about monetary policy along the
left hand side. Along the top is whether the multiplier
value is for a change in government spending (G) or a
In trying to explain the unexpected weakness
tax cut (T).
of GDP growth over this period, it is natural
The above table is for the fourth quarter under which a
to ask whether it was caused in part by [scal]
permanent change in policy is in force.[8]
tightening either because it turned out to be
larger than we had originally assumed or beIn 2013 a study has been published examining economic
cause a given tightening did more to depress
features that impact scal multipliers. It found that the
GDP than we had originally assumed.
output eect of an increase in government consumption is
larger in industrial than in developing countries, the scal
In answering the question, we are concerned
multiplier is relatively large in economies operating under
with the aggregate impact of dierent types of
predetermined exchange rate but zero in economies opscal tightening on GDP (measured using soerating under exible exchange rates; scal multipliers in
called scal multipliers) and not simply the
open economies are lower than in closed economies and
direct contribution that government investment
scal multipliers in high-debt countries are also zero.[9]
and consumption of goods and services makes
to the expenditure measure of GDP. This direct government contribution has been more
5.2 Europe
positive for growth than we expected, rather
than more negative.[15]
Italian economists have estimated multiplier values ranging from 1.4 up to 2.0 when dynamic eects are accounted for. The economists used maa inuence as an
instrumental variable to help estimate the eect of central
funds given to local councils.[10]
6 Criticisms

5.3

IMF

In October 2012 the International Monetary Fund released their Global Prospects and Policies document in
which an admission was made that their assumptions
about scal multipliers had been inaccurate.
IMF sta reports, suggest that scal multipliers used in the forecasting process are

6.1 Crowding out

It has been claimed that scal activity does not always
lead to increased economic activity because decit spending used to nance spending or tax cuts can crowd out nancing for other economic activity. This phenomenon is
argued to be less likely to occur in a recession, where savings rates are traditionally higher and capital is not being
fully utilized in the private market.[16]

6.2

Marginal Propensity to Consume

As has been discussed, the Multiplier relies on the MPC

(Marginal Propensity to Consume). The use of the term
MPC here, is a reference to the MPC of a country (or
similar economic unit) as a whole, and the theory and
the mathematical formulae apply to this use of the term.
However, individuals have an MPC, and furthermore
MPC is not homogeneous across society. Even if it was,
the nature of the consumption is not homogeneous. Some
consumption may be seen as more benevolent (to the
economy) than others. Therefore spending could be targeted where it would do most benet, and thus generate
the highest (closest to 1) MPC. This has traditionally been
regarded as construction or other major projects (which
also bring a direct benet in the form of the nished product).
Clearly, some sectors of society are likely to have a much
higher MPC than others. Someone with above average
wealth or income or both may have a very low (short term,
at least) MPC of nearly zerosaving most of any extra
income. But a pensioner, for example, will have an MPC
of 1 or even greater than 1. This is because a pensioner
is quite likely to spend every penny of any extra income.
Further, if the extra income is seen as regular extra income, and guaranteed into the future, the pensioner may
actually spend MORE than the extra 1. This would occur where the extra income stream gives condence that
the individual does not need to put aside as much in the
form of savings, or perhaps can even dip into existing savings.
More importantly, this consumption is much more likely
to occur in local small businesslocal shops, pubs and
other leisure activities for example. These types of businesses are themselves likely to have a high MPC, and
again the nature of their consumption is likely to be in
the same, or next tier of businesses, and also of a benevolent nature.
Other individuals with a high, and benevolent, MPC
would include almost anyone on a low incomestudents,
parents with young children, and the unemployed.

6.3

Externalities

It has also been argued that over-reliance upon scal multipliers can lead to the neglect of externalities such as environmental degradation, unsustainable resource depletion or social consequences. Negative consequences of
over-reliance upon scal multiplication values can either
be envisaged in increased government spending on activities with high scal multiplication values which create negative externalities (pollution, climate change, resource depletion, etc.) or through decreased spending on
activities which create low immediate scal multiplication values but create positive externalities (educational
standards, social cohesion, public health, etc.).[17]

7 See also
Complex multiplier
Fiscal policy
Keynesian economics
Local multiplier eect
Transfer payments multiplier
Multiplier uncertainty

8 References
[1] Snowdon, Brian; Vane, Howard R. (2005). Modern
macroeconomics: its origins, development and current
state. Edward Elgar. p. 61. ISBN 978-1-84542-208-0.
[2] Coates, Dennis; Humphreys, Brad R. (October 27, 2004).
Caught Stealing: Debunking the Economic Case for D.C.
Baseball. Cato Insititute Brieng Papers (Cato Institute)
(89). Retrieved 2011-10-10.
[3] Much ado about multipliers. The Economist. Sep 24,
2009. Retrieved 18 October 2011.
[4] A Labor Force Built to Last. United States Department
of Labor. Retrieved 21 February 2012.
[5] Rendahl, Pontus (26 April 2012). A case for balancedbudget stimulus. VoxEU.org.
[6] http://www.choicesmagazine.org/2003-2/2003-2-06.
htm retrieved 27 September 2007.
[7] Zandi, Mark. A Second Quick Boost From Government
Could Spark Recovery. Edited excerpts from congressional testimony July 24, 2008.
[8] Eckstein, Otto (1983). The DRI Model of the US Economy.
New York: McGraw-Hill. ISBN 0-07-018972-2. See
also Bodkin, Ronald G.; Eckstein, Otto (1985). The DRI
Model of the U. S. Economy. Southern Economic Journal 51 (4): 12531255. doi:10.2307/1058399. JSTOR
1058399.
[9] Ilzetzki, Ethan; Mendoza, Enrique G.; Vgh, Carlos
A. (2013). How Big (Small?) are Fiscal Multipliers?". Journal of Monetary Economics 60 (2): 239254.
doi:10.1016/j.jmoneco.2012.10.011.
[10] Acconcia, A.; Corsetti, G.; Simonelli, S. (2011). Maa
and Public Spending: Evidence on the Fiscal Multiplier
from a Quasi Experiment. CEPR Discussion Paper 8305.
SSRN 1810270. See also http://voxeu.org/index.php?q=
node/6314.
[11] IMF Global Prospects and Policies report 2012, page 43
[12] Osbornes indiscriminate austerity
[13] Fiscal multipliers, the IMF and the OBR

9 FURTHER READING

[14] George Osbornes austerity is costing UK an extra 76bn,

says IMF
[15] 2012 OBR Forecast Evaluation Report, page 53
[16] Woodford, Michael (2011). Simple Analytics of the
Government Expenditure Multiplier. American Economic Journal: Macroeconomics 3 (1): 135. JSTOR
41237130.
[17] What is... scal multiplication

Further reading
Dornbusch, Rdiger; Fischer, Stanley (1990).
Macroeconomics (Fifth ed.). New York: McGrawHill. pp. 7890. ISBN 0-07-017787-2.

10
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