The fiscal multiplier measures the impact of a fiscal stimulus on the Gross Domestic Product (GDP) of an economy. Fiscal stimulus is the increase in government spending to stimulate the economy. The fiscal multiplier should not be confused with the monetary multiplier, which is the impact of change in money supply on the output of an economy.
The monetary multiplier is driven by the central bank, which controls the money supply via the interest rates. The fiscal multiplier is driven by government spending on tangible things like building infrastructure or social programs.
There are two types of fiscal multipliers – the expenditure multiplier and the revenue multiplier:
Expenditure Multiplier: It measures the change in output for every extra dollar spent by the government. The formula for the expenditure multiplier is given below:
Delta Y = Change in Output
Delta G = Change in Government Spending
Revenue Multiplier: It measures the change in output for every dollar increase in revenues collected by the government. The formula for the revenue multiplier is given below:
Delta Y = Change in Output
Delta T = Change in Taxes or Government Revenue
Measuring the Fiscal Multiplier
The fiscal multiplier is extremely difficult to estimate. It is because the economy is complex, with multiple forces affecting its output. In such a situation, it becomes too hard to pinpoint the change in output that is directly attributable to fiscal policy.
There are two main approaches to estimating the fiscal multiplier. First is the econometric or statistical approach, and the second in the simulation or model-based approach.
1. Econometric Estimation
The econometric estimation of the fiscal multiplier is performed using a statistical model called a Structural Vector Autoregressive model or an SVAR model. The model is a multivariate time series model that measures the relationship between multiple variables through time. The SVAR approach requires a lot of data, which is not always available. Hence, even though the method is based on data, the results may not be stable.
2. Model-Based Estimation
The model-based estimation approach creates a model of the economy and then uses simulation to estimate the required variable. The models that are often used to model the economy are known as Dynamic Stochastic General Equilibrium (DSGE) models.
They model different sectors of the economy and the interaction among them. The simulations from the models are aggregated to measure the required variable, in our case, the fiscal multiplier. Such an approach does not require a lot of data, but it suffers from model risk.
3. Bucket Approach
The bucket approach is a very simple method that estimates the fiscal multiplier depending on how an economy ranks on various factors. It is more of a back of the envelope calculation, which can provide a ballpark figure for the multiplier based on the experience of other economies with similar features.
Factors Affecting the Multiplier
Many factors affect the size of the multiplier. Generally speaking, the higher the control of the government on the economy, the higher the fiscal multiplier. The factors are of two types:
Structural factors are the permanent features of the economy. Different economies respond differently to fiscal stimulus. The following are some important structural factors that affect the size of the fiscal multiplier:
High levels of debt can reduce the impact of the fiscal multiplier. It is because any fiscal stimulus is used to service debt before being used for more productive activities. Hence, the output increases by a smaller amount, which means the fiscal multiplier is reduced.
The size of the fiscal multiplier is inversely proportional to the trade openness. If there are high restrictions on trade, then the fiscal stimulus can be more effective because the output does not depend on the global economy. Higher dependence on an external economy means the domestic economy cannot productively absorb the fiscal stimulus if the global economy remains weak.
Exchange Rate Regime
A more flexible interest rate regime leads to a smaller multiplier. It happens because any growth push created by the fiscal stimulus can be offset by a reduction in the value of the currency, which implies a reduction in the purchasing power.
Conjunctural factors are transient features of the economy that can affect the size of the multiplier. Two main conjunctural factors are:
The fiscal multiplier tends to be larger during a downturn compared to an expansion. In an expansion, there is little capacity to absorb government spending, and any fiscal stimulus crowds out private consumption. Hence, the multiplier remains low.
An accommodative monetary policy can greatly increase the fiscal multiplier, which means when interest rates are low, the impact of the fiscal stimulus is higher. A lower cost of capital acts as a catalyst to growth in the output, and even small amounts of fiscal stimulus can grow the output. It is a matter of recent importance, as governments around the world are increasing spending in tandem with interest rates being reduced to the Zero Lower Bound (ZLB).