In economics, the
fiscal multiplier is the ratio of a change in national income to the change in government spending that causes it. More generally, the
exogenous spending multiplier is the ratio of a change in national income to any autonomous change in spending (private investment spending, consumer spending, government spending, or spending by foreigners on the country's exports) that causes it. When this multiplier exceeds one, the enhanced effect on national income is 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
consumptionConsumption is a common concept in economics, and gives rise to derived concepts such as consumer debt. Generally, consumption is defined in part by comparison to production. But the precise definition can vary because different schools of economists define production quite differently...
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 demandIn macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...
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
Richard KahnRichard Ferdinand Kahn, Baron Kahn, CBE, FBA was a British economist.Kahn was born in Hampstead to Augustus Kahn, a German schoolmaster and an orthodox Jew, and Regina Schoyer. He raised in England and was educated on St Paul's School, London...
in 1930 and published in 1931. It is particularly associated with
Keynesian economicsKeynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...
. 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 demandIn macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...
.
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 investmentFixed investment in economics refers to investment in fixed capital, i.e., tangible capital goods , or to the replacement of depreciated capital goods which have been scrapped....
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 rateAn interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
s or in the
price levelA price level is a hypothetical measure of overall prices for some set of goods and services, in a given region during a given interval, normalized relative to some base set...
. In general, the only thing that can be said with certainty is that "economists are in fact deeply divided about how well, or indeed whether, such stimulus works."
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 a significant proportion of the $1 in due course, making the net expenditure much less than $1. Indeed, in theory, it is possible, if the initial expenditure is targeted well, that the government could receive back more than the initial $1 expended.
Examples
For example: a company spends $1 million to build a factory. The money does not disappear, but rather becomes wages to builders,
revenueIn business, revenue is income that a company receives from its normal business activities, usually from the sale of goods and services to customers. In many countries, such as the United Kingdom, revenue is referred to as turnover....
to suppliers etc. The builders will have higher
disposable incomeDisposable income is total personal income minus personal current taxes. In national accounts definitions, personal income, minus personal current taxes equals disposable personal income...
as a result, consumption rises as well, and hence
aggregate demandIn macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...
will also rise. Suppose further that recipients of the new spending by the builder in turn spend their new income, this will raise consumption and demand further, and so on.
The increase in the
gross domestic productGross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....
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 subcontractors 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.
Another example: when tourists visit somewhere they need to buy the plane ticket, catch a taxi from the airport to the hotel, book in at the hotel, eat at the restaurant and go to the movies or tourist destination. The taxi driver needs petrol (gasoline) for his cab, the hotel needs to hire the staff, the restaurant needs attendants and chefs, and the movies and tourist destinations need staff and cleaners.
Applications
The multiplier effect is a tool used by governments to attempt to stimulate aggregate demand. This can be done in a period of recession or economic uncertainty. The money invested by a government creates more jobs, which in turn will mean more spending and so on.
The idea is that the net increase in disposable income by all parties throughout the economy will be greater than the original investment. When that is the case, the government can increase the gross domestic product by an amount that is greater than an increase in the amount it spends relative to the amount it collects in taxes.
The difference is the 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 resulting
deficit spendingDeficit spending is the amount by which a government, private company, or individual's spending exceeds income over a particular period of time, also called simply "deficit," or "budget deficit," the opposite of budget surplus....
must be financed from government reserves (if any) or net borrowing from private or foreign investors. 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.
It must be noted that the extent of the multiplier effect is dependent upon the
marginal propensity to consumeIn economics, the marginal propensity to consume is an empirical metric that quantifies induced consumption, the concept that the increase in personal consumer spending occurs with an increase in disposable income...
and
marginal propensity to importThe marginal propensity to import refers to the change in import expenditure that occurs with a change in disposable income...
. Also that the multiplier can work in reverse as well, so an initial fall in spending can trigger further falls in aggregate output.
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.
Various types of fiscal multipliers
The following values are theoretical values based on simplified 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 first component.
- y is original output (GDP)
is marginal propensity to consume (MPC)
is original income tax rate
is marginal propensity to import
is change in income (equivalent to GDP)
is change in lump-sum tax rate
is change in income tax rate
is change in government spending
is change in aggregate taxes
is change in investment
is change in exports
Standard Income Tax Equation
Note: only
is here because if this is a change in income tax rate then
is implied to be 0.
Standard Government Spending Equation
Standard Investment Equation
Standard Exports Equation
Balanced-Budget Government Spending Equation
United States of America
In congressional testimony given in July 2008,
Mark ZandiMark Zandi is an Iranian American economist and co-founder of Moody's Economy.com, a widely-cited source of economic analysis.. Moody's Economy.com is part of Moody's Analytics. Prior to founding Economy.com, Zandi was a regional economist at Chase Econometrics.He was born in Atlanta, Georgia of...
, chief economist for
Moody'sMoody's Corporation is the holding company for Moody's Analytics and Moody's Investors Service, a credit rating agency which performs international financial research and analysis on commercial and government entities. The company also ranks the credit-worthiness of borrowers using a standardized...
Economy.com, provided estimates of the one-year multiplier effect for several fiscal policy options. The multipliers showed that any form of increased government spending would have more of a multiplier effect than any form of tax cuts. The most effective policy, a temporary increase in
food stampsThe United States Supplemental Nutrition Assistance Program , historically and commonly known as the Food Stamp Program, is a federal-assistance program that provides assistance to low- and no-income people and families living in the U.S. Though the program is administered by the U.S. Department of...
, had an estimated multiplier of 1.73. The lowest multiplier for a spending increase was general aid to
stateA U.S. state is any one of the 50 federated states of the United States of America that share sovereignty with the federal government. Because of this shared sovereignty, an American is a citizen both of the federal entity and of his or her state of domicile. Four states use the official title of...
governments, 1.36. Among tax cuts, multipliers ranged from 1.29 for a payroll tax holiday down to 0.27 for accelerated
depreciationDepreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
. Making the
Bush tax cutsThe Bush tax cuts refers to changes to the United States tax code passed during the presidency of George W. Bush and extended during the presidency of Barack Obama that generally lowered tax rates and revised the code specifying taxation in the United States...
permanent had the second-lowest multiplier, 0.29. Refundable lump-sum tax rebates, the policy used in the
Economic Stimulus Act of 2008The Economic Stimulus Act of 2008 was an Act of Congress providing for several kinds of economic stimuli intended to boost the United States economy in 2008 and to avert a recession, or ameliorate economic conditions. The stimulus package was passed by the U.S. House of Representatives on January...
, had the second-largest multiplier for a tax cut, 1.26.
Robert J. Barro estimated that government spending has a multiplier of around 0.8, meaning for $1.00 spent, the economy gets $0.80. In addition, the spending must be repaid in the future most likely with tax increases which he assumes to have a multiplier of -1.1. This results in a further decrease in GDP and concludes that government spending actually has more cost than benefit.
According to
Otto EcksteinOtto Eckstein was a German-born economist at Harvard University, member of the President's Council of Economic Advisers from 1964 to 1968), and co-founder of Data Resources Inc. He received an A.B. from Princeton University and a Ph.D...
, estimation has found "textbook" values of multipliers are overstated. The following 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 (ΔG) or a tax cut (-ΔT).
| Monetary Policy Assumption |
ΔY/ΔG |
ΔY/(-ΔT) |
| Interest Rate Constant |
1.93 |
1.19 |
| Money Supply Constant |
0.6 |
0.26 |
The above table is for the fourth quarter under which a permanent change in policy is in force.
Europe
Italian economists have estimated multiplier values ranging from 1.4 up to 2.0 when dynamic effects are accounted for. The economists used mafia influence as an
instrumental variableIn statistics, econometrics, epidemiology and related disciplines, the method of instrumental variables is used to estimate causal relationships when controlled experiments are not feasible....
to help estimate the effect of central funds given to local councils.
Crowding out
Fiscal activity does not always lead to increased economic activity because deficit spending used to finance spending or tax cuts can crowd out financing for other economic activity. Of course, 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.
Marginal Propensity to Consume, targeting the Multiplier and "benevolent" consumption
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 benefit, 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 benefit in the form of the finished 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 zero - saving 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 confidence 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 business - local 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 income - students, parents with young children, and of course, the unemployed.
See also
- Multiplier (economics)
In economics, the fiscal multiplier is the ratio of a change in national income to the change in government spending that causes it. More generally, the exogenous spending multiplier is the ratio of a change in national income to any autonomous change in spending In economics, the fiscal...
- Multiplier uncertainty
In macroeconomics, multiplier uncertainty is lack of perfect knowledge of the multiplier effect of a particular policy action, such as a monetary or fiscal policy change, upon the intended target of the policy...
- Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...
- Fiscal policy
In economics and political science, fiscal policy is the use of government expenditure and revenue collection to influence the economy....
- Local multiplier effect
The local multiplier effect refers to the greater local economic return generated by money spent at locally-owned independent businesses compared to corporate chains or other absentee-owned businesses...