TERM PAPER

Macro and Micro Economics

Student ID Number: 162368

Fiscal Multiplier

Table of content

Chapter 1

Abstract ……………………………………………………………… 1
Introduction ……………………………………………………………. 1

Chapter 2

Literature review …………………………………………………………2- 4

Chapter 3

Fiscal Multiplier ………………………………………………………… 5

- Government spending …………………………………………………. 6
- Taxes …………………………………………………………………... 7
- Challenges……………………………………………………………… 7
- Conclusion ……………………………………………………………. 8

Figures

Fig 1. Government Expenditure ………………………………………... 6

Fig 2. Taxes ……………………………………………………………...7

Reference ………………………………………………………………. 9
1.1 Abstract

Fiscal multipliers are important tools for macroeconomic projections and policy
design. In many countries, little is known about the size of multipliers, as data
availability limits the scope for empirical research. This study provides general
guidance on the definition, measurement, and use of fiscal multipliers. It reviews the
literature related to when it was implemented, and determinants. Finally, the study
looks at how fiscal multiplier changes due to economic cycle.

Keywords: Fiscal Multiplier, Government spending, Taxes and economy.

1.2 Introduction

Fiscal policy is the use of government expenditure and taxation to impact the
economy, particularly macroeconomic conditions. These include employment,
inflation, economic expansion, and the aggregate demand for goods and services.
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 study will look on how fiscal policy through government spending and taxes will
result in a multiplier on the economy. To analyze the fiscal multiplier of an economy,
Aggregate demand such as Consumption, Investment, Government spending and
Export-Import are used to examine the changes in the multiplier. The dependent
valuables will be government expenditure and Taxes. The independent will be the
Aggregate demand.
They are two types of fiscal multiplier; expenditure multiplier and revenue or taxes
multiplier.
Fiscal multipliers tend to be larger when interest rates are near the zero lower bound
or when monetary policy accommodates government spending.
Fiscal multipliers are greater in industrial countries such as china and Japan, in
presence of fixed exchange rates and in closed economies.

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2. Literature review

Fiscal multipliers measure the short-term impact of discretionary fiscal policy on

output. They are usually defined as the ratio of a change in output to an exogenous
change in government spending or tax with respect to their baselines. Economic
theory predicts different sizes for fiscal multipliers, depending on which school of
thought is considered.

Neoclassical economics, on the other hand, downplays the importance of multiplier

effects. According to the standard neoclassical model, which sees consumers and
producers quick to respond to price signals, deficit spending requires the government
to borrow, which may lead to higher interest rates, thus crowding out private
investment and weakening the effects of fiscal policy. Another argument, known as
the Ricardian equivalence (Barro 1996), claims that households may see higher
government spending leading to higher future tax liability, which reduces their
lifetime income. As a result, households may decide to reduce their current
consumption, setting fiscal multipliers at zero. If households decide to work more,
output will be higher, making fiscal multipliers positive; but they will be less than 1.0
because of the negative wealth effect on lifetime income that reduces current
consumption.

Even within Keynesian economic models, different structural characteristics of the

economy, such as trade openness, labor market rigidity, the size of automatic
stabilizers, the exchange rate Estimating Fiscal Multipliers in Selected Asian
Economies 3 regime, the debt level, and public expenditure management, can lead to
different predictions for fiscal multipliers (Batini et al. 2014). For example, less open
countries tend to have higher fiscal multipliers because the demand leakage through
imports is smaller. Wage rigidity can amplify the response of output to fiscal policy
shocks. Exchange rate rigidity can also increase the size of fiscal multipliers because
exchange rate movements may offset the impact of discretionary fiscal policy on the
economy. On the other hand, countries with high levels of debt tend to have lower
multiplier effects, as fiscal stimulus is likely to have negative credibility and
confidence impacts on private demand and the interest rate risk premium. Automatic
stabilizers such as taxes and transfers tend to reduce fiscal multipliers as they can
offset part of the initial fiscal shocks. Multipliers are also expected to be smaller when
difficulties to collect taxes and expenditure inefficiencies limit the impact of fiscal
policy on output.

In addition to these structural characteristics, the size of fiscal multipliers also

depends on some transitory factors that reflect the condition of the economy (Farhi
and Werning 2016). One is the state of the business cycle. Fiscal multiplier effects are
believed to be larger during recessions than during expansions—although, recent
empirical studies show that tax multipliers are higher in absolute value during
expansions than during recessions (Ramey 2019). A fiscal stimulus is likely to be less
effective during the expansion stage because, at closer to full capacity, an increase in
public demand can crowd out private demand. A fiscal consolidation is more costly in
terms of output loss in a downturn because credit-constrained agents cannot borrow to
smooth their consumption. It has also been noted that a downturn has a stronger effect
on multipliers than an upturn, i.e., multipliers increase more in a recession than they
decrease in an expansion (Batini et al. 2014).

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 Another important transitory factor that influences the size of fiscal multipliers is the
degree of monetary accommodation to fiscal shocks. Expansionary monetary policy
can cushion a fiscal stimulus package’s upward impact on interest rates, thus avoiding
or reducing the crowding-out effects and increasing the size of fiscal multipliers. In
the case of fiscal consolidation, a lowering of interest rates can soften the impact on
demand, making multipliers smaller. Recent works on the zero lower bound interest
rates have also examined the monetary implication of a fiscal stimulus. In an
environment where the nominal interest rates hit the zero lower bound, fiscal
measures will be particularly effective since crowding out of investment from higher
interest rates is largely absent, and the economy at this stage is likely to be operating
at ample excess capacity (Woodford 2010; Christiano, Eichenbaum, and Rebelo 2011;
Cloyne, Jorda, and Taylor 2020).

The empirical literature on fiscal multipliers is vast, and most studies focus on
developed countries. A literature survey by Ramey (2019) found that most estimates
of general government spending multipliers range from 0.6 to 0.8 or up to 1.0, using
either time series analysis (typically structural vector auto regression models of either
a single country or panel of countries) or dynamic stochastic general equilibrium
(DSGE) models. These estimates referred to cumulative multipliers over horizons
between 0 and 20 quarters. The survey also noted the evidence of multipliers greater
than 1.0 during recessions or times of slack, although considered not sufficiently
robust, and being higher at times when monetary policy accommodates fiscal
measures (such as during wartime or the period at the zero-lower bound). On the other
hand, based on a survey of studies on the US, Whalen and Reichling (2015) reported
that the 4-quarter cumulative multiplier of federal transfers to state and local
governments for infrastructure investment can reach as high as 2.5. Findings of public
investment having higher fiscal multipliers than general government spending are also
confirmed by Alloza, Burriel, and Pérez (2018), who reported that the 4-quarter
cumulative multiplier of public investment in the euro area is 1.91 and the 8-quarter
multiplier is 3.17.

Ramey (2019) also reported empirical estimates of the cumulative tax multipliers (the
largest within the first 5 years) and found these are at least –2.0 to –3.0,1 much higher
than the spending multipliers in absolute values, opposite to what the theory predicts.2
But Ramey noted that the tax multipliers estimated from DSGE models are typically
below 1.0 and never higher than 1.5 (in absolute value).
Similar findings were noted among empirical studies that, unlike spending multipliers
which are counter cyclical, tax multipliers are in fact pro cyclical, i.e., their absolute
values are larger during expansions than during recessions. While most empirical
studies on fiscal multipliers have focused on developed countries, a few studies have
made attempts in the context of developing countries. Compared with developed
countries, there are reasons to predict that the size of fiscal multipliers for developing
countries are larger, but there are also reasons to believe that these are smaller (Batini
et al. 2014).
The reasons for predicting larger fiscal multipliers for developing countries include
greater liquidity constraints, less effective monetary policy responses and
transmissions, lower automatic stabilizers, lower levels of public debt, and greater
slacks in the economy (such as higher levels of unemployment and
underemployment).

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The reasons for believing in smaller fiscal multipliers in developing countries include
larger precautionary savings due to a more uncertain environment, less efficient
management of public expenditure and revenue, lower credibility of fiscal policy due
to higher interest rate spreads, and smaller and more open economies. Batini et al.
(2014) provided a survey of empirical studies on fiscal multipliers for developing
countries, including those in Asia, Latin America and the Caribbean, the Middle East,
Europe, and Africa.

Most estimates of the first-year general government spending multipliers, including

those of developing Asian economies, are in the range between 0.1 and 0.5, either
from single country studies or panel estimations. These are much smaller than the
spending multipliers for developed countries. One notable exception is the estimate
for the People’s Republic of China (PRC), which is larger than 2.0, as reported by
Wang and Wen (2013). Spending multipliers for oil-exporting countries were also
found to be larger, i.e., close to 1.0. Similar to the findings for developed countries,
the public investment multiplier was found to be greater than that of general
government spending, as reported by Rafiq and Zeufack (2012) in the case of
Malaysia: 2.7 during downturns and 2.0 during upturns. In the case of tax multipliers,
the average absolute value of the estimates from about 20 studies surveyed is 0.26,
with more than half reporting zero value. Batini et al. (2014) also noted empirical
findings that greater trade openness and more flexible exchange rates reduce fiscal
multipliers.

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3. Fiscal Multiplier
The fiscal multiplier estimates the final change in real national income(GDP) that
results from an initial (exogenous) change in government spending and/ or revenue
plans. For example; if a $5 billion increase in government spending flood defence
leads to a $12 billion final increase in real GDP, then the fiscal multiplier is $12
billion/ $5 billion = +2.4 multiplier effect.

The size of the fiscal Multiplier depends on how the fiscal stimulus such as
government spending is financed, if it’s through debt. Extent to which a tax leads to
higher interest rates or inflation. Degree to which an economy is opened to imports,
Having more imports can lead to a negative fiscal multiplier. Impact on consumer and
business expectations and confidence. For instance, an increase in Government
spending will increase consumption while an increase in taxes reduces consumption.
Marginal propensity to consume and save of households affected.

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.

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.
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 accommodating 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.
If the fiscal multiplier is a high positive number, then a well-timed fiscal stimulus
might be highly effective in helping to lift aggregate demand, production, incomes
and jobs ad an economy tries to recover from a deep recession/ downturn.

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.

Fiscal multiplier theory posits that as long as a country's overall MPC is greater than
zero, then an initial infusion of government spending should lead to a
disproportionately larger increase in national income. The fiscal multiplier expresses
how much greater or, if stimulus turns out to be counterproductive, smaller the overall
gain in national income is when compared with the amount of extra spending.

The formula for the fiscal multiplier is as follows:

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 Fiscal Multiplier=1−MPC1
where:MPC=marginal propensity to consume
The higher the MPC, the greater other things been the same will be the size of the
multiplier.

Fiscal multiplier depends on ; Government spending and Taxes

3.1 Government spending

Government spending represents an injection into the economy whereas taxes are a
withdrawal or leakages.

The government may use fiscal policy to intervene in the economy in the following
ways;
- By spending more money and financing this expenditure through borrowing
- By collecting more in taxes without increasing expenditure
-By collecting more in taxes with the aim of increasing spending.

Government spending create a multiplier effect on national income.

Fig 1. Government spending is expansionary

AD
E=Y
AD= C+I+G2
E22
AD=C+I+G1

G E1

Y11 Y2
Income Y

From fig 1, an increase in Government spending, leaving the other factors constant ,
create a shift in the aggregate demand curve, making it parallel to the first curve.
An example of a fiscal multiplier, can be the waiyaki way and mombassa road that
was built recently, the road created many opportunity to residence that leaves the near
the place and called for more businesses in those areas. We can denotate that change
in income is equal 5 times change in Government spending, meaning that an increase
in government spending causes income to increase 5 times.
This increase in government spending reduced unemployment leading to a decrease in
poverty for he country. We can also say that Government spending increases the
living standard of the country.
An other good example is the country Ethiopia that decided that the government
should be spending on most of the countries improvement and Ethiopia has been
doing much more better recently.

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 3.2 Taxes

Fig 2. Taxes

E=Y E=Y
AE

AE=C1+I+G

AE=C2+I+G
C1

C2

Y2 Y1
Real GDP
A tax increases reduces disposable income so consumption spending falls.
The economy is in equilibrium when:
1. aggregate expenditures = real GDP
2. unplanned change in inventory = zero
3. leakages = injections
Equilibrium does not need to be at potential GDP. The economy can be in equilibrium
at less than full employment.
3.4 Challenges estimating fiscal multiplier
1. Difficult to isolate direct effect of fiscal measures on GDP because of the two-
way relationships between the variables.
2. Multipliers only consider GDP. Other variables such as employment, social
outcomes and income distribution are excluded.
3. There is limited data availability for estimating multipliers

3.5 Conclusion

Fiscal multipliers are important because they can help guide a government's policies
during an economic crisis and help set the stage for economic recovery.

Government spending allows demand-constrained firms to boost output, raising

economy-wide income and employment. Households then spend part of the higher
income, which generates income and employment further. As this process continues,
the cumulative impacts on output can drive fiscal multipliers to values greater than

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1.0. In the case of tax cuts, the multiplier effects will be lower because, unlike
government spending, which directly feeds into the economy and increases income,
households may decide to save part of their income, therefore creating less new
economic activities.

Output effect of an exogenous fiscal shock vanishes within 5yrs even though fiscal
measures are permanent.
The effect does not decline linearly but it has an inverted U-shape with maximum
impact on 2yrs.
Permanent fiscal measures tend to have more persistent output effects than temporary
ones.

We can conclude the study by saying that, fiscal multiplier is a big factor to the
economy of a country. Developed countries are growing because their fiscal
multiplier is higher, the government control most of the countries production.
However countries like sub-saharan, whereby the government spending is less, the
countries faces a major problem in unemployment that has been reuslted from a low
government spending that can produce jobs for the population. A good example of a
fiscal multiplier is a country like china, in china 75% of resources are controlled by
the government, they make sure that every year , government spending is increased to
carter for the undergraduates that just finished.

The researcher recommendation is that, developed countries should increase

infrastructure, which will create more jobs, decreasing prices and increasing real
income for consumers from cutting down value added tax.

References

1. Alloza, M., Burriel, P. and Pérez, J.J., 2018. Fiscal policies in the euro area:
revisiting the size of spillovers.

2. Batini, N., Eyraud, L., Forni, L. and Weber, A., 2014. Fiscal multipliers: Size,
determinants, and use in macroeconomic projections. International Monetary Fund.

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3. Christiano, L., Eichenbaum, M. and Rebelo, S., 2011. When is the government
spending multiplier large?. Journal of Political Economy, 119(1), pp.78-121.

4. Cloyne, J.S., Jordà, Ò. and Taylor, A.M., 2020. Decomposing the fiscal

multiplier (No. w26939). National Bureau of Economic Research.

5. Farhi, E. and Werning, I., 2016. Fiscal multipliers: Liquidity traps and currency
unions. In Handbook of macroeconomics (Vol. 2, pp. 2417-2492).

6. Rafiq, S. and Zeufack, A., 2012. Fiscal multipliers over the growth cycle: evidence
from Malaysia. World Bank Policy Research Working Paper, (5982).

7. Ramey, V.A., 2019. Ten years after the financial crisis: What have we learned from
the renaissance in fiscal research?. Journal of Economic Perspectives, 33(2), pp.89-
114.

8. Whalen, C.J. and Reichling, F., 2015. The fiscal multiplier and economic policy
analysis in the United States. Contemporary Economic Policy, 33(4), pp.735-746.
9.
10. Woodford, M., 2010. Financial intermediation and macroeconomic
analysis. Journal of Economic Perspectives, 24(4), pp.21-44.