Define the fiscal multiplier.
The fiscal multiplier assesses how fiscal spending increases impact a nation’s GDP. Most economists define fiscal multipliers as the production ratio to tax income or government spending. Fiscal multipliers guide government decisions during economic crises and stimulate recovery.
Understanding Fiscal Multipliers
In a 1931 study, John Maynard Keynes’s student Richard Kahn introduced the fiscal multiplier, a ratio that shows the causal relationship between fiscal policy changes and GDP outcomes.
If a country’s MPC is more significant than zero, the fiscal multiplier theory suggests that increasing government expenditure should result in a disproportionate rise in national revenue. The budgetary multiplier shows how much more or less national income is gained compared to increased spending if stimulus fails. Fiscal multiplier formula:
Multiplier = 11 – MPCMPC = marginal propensity to consume. The fiscal multiplier is one minus the marginal propensity to consume (MPC).
Example of Fiscal Multiplier
Suppose a national government provides a $1 billion fiscal boost and consumers’ MPC is 0.75. Consumers receiving the initial $1 billion will save $250 million and spend $750 million, triggering a smaller stimulus. The receivers of $750 million will spend $562.5 million, etc.
National income changes by the initial rise in government, or “autonomous,” expenditure times the fiscal multiplier. The marginal propensity to consume is 0.75. Hence, the budgetary multiplier is 4. The initial $1 billion in fiscal stimulus would enhance national revenue by $4 billion, according to Keynesian theory.
This is one of several multipliers used by economists to analyze economic activity, such as the earnings and investment multipliers.
Real-World Fiscal Multiplier
Spending and growth are messier than theory indicates, according to empirical research. Different people have different MPCs. Low-income families spend more on a windfall than high-income ones. The form of the fiscal stimulus affects MPC. Other policies can have quite different budgetary multipliers.
In 2009, Moody’s chief economist Mark Zandi calculated fiscal multipliers for several policy alternatives, based on one-year dollar increases in real GDP per dollar increase in expenditure or drop in federal tax revenue:2
|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|
|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|
|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|
This research suggests that temporarily raising food stamps (1.74), federally funding work-share programs (1.69), and extending unemployment insurance benefits (1.61) are the most successful policy alternatives. These strategies focus on low-income populations with high marginal consumption propensities. For every dollar “spent” (given up in tax revenue) in permanent tax cuts for largely higher-income people, just a few cents contribute to actual GDP.
The fiscal multiplier has fluctuated in policy. Although Keynesian theory was prominent in the 1960s, stagflation, which Keynesians struggled to explain, led to a decline in trust in fiscal stimulation. Since the 1970s, policymakers have favored monetarist approaches, thinking that managing the money supply is equally successful as government expenditure.
Since the 2008 financial crisis, the fiscal multiplier has regained some prominence. Investment in budgetary stimulus led to a faster and more robust recovery in the U.S. compared to Europe, where bailouts were tied to fiscal austerity.
- The fiscal multiplier measures how fiscal spending increases affect a nation’s GDP.
- Fiscal multiplier theory relies on marginal propensity to consume (MPC), which measures how much an increase in income affects consumer spending rather than saving.
- Lower-income households have a greater MPC, according to evidence.