What is likely to be the impact of a government stimulus or austerity plan in response to the coronavirus crisis on the whole economy? That is what is measured by the ‘fiscal multiplier’ – and the evidence indicates that increased public spending has a bigger impact during recessions.
During the lockdown, when businesses are forced to shut and lots of people are not able to go to work because of the risk of spreading the Covid-19 virus, the need for support by the government is obvious. The interesting question from an economic point of view is how far can and should government support go in terms of transfers to households and businesses, loans and tax breaks.
The answer to that question depends crucially on a concept called the fiscal multiplier. Here, we explain what the multiplier is, how we measure it and why it matters today.
What is the fiscal multiplier?
The fiscal multiplier is defined as the ratio of the change in national income arising from an exogenous change in government spending or revenue plans. Multipliers are computed to evaluate the macroeconomic impact of a government stimulus or austerity plan.
The idea, originally expressed by Richard Kahn in 1931, relates to the extent which a change in government spending plans raises income for households and firms and causes them also to change their expenditure, which amplifies the impact of the original ‘injection’ or ‘withdrawal’ (Kahn, 1931).
When there is a temporary decline in aggregate demand, governments justify a fiscal stimulus with the argument that more public spending or lower taxes may stimulate private consumption or investment via this multiplier effect.
What does economic research tell us about the fiscal multiplier?
The economic consensus on the fiscal multiplier in normal times is that it tends to be small, typically smaller than 1. This is for two reasons:
- First, increases in government expenditure need to be financed, and thus come with a negative ‘wealth effect’, which crowds out consumption and decreases demand.
- Second, a fiscal expansion, increasing inflation and output, triggers a response by the central banks, which raises interest rates, offsetting some of the expansionary effect of fiscal policy.
Economic research suggests that the fiscal multiplier is higher than normal when:
- There is a large proportion of liquidity-constrained consumers, which means that that they would consume more if they were able to borrow more.
- The policy interest rate is at the zero lower bound (ZLB), which means that the central bank sets its short-term interest rate at or near to 0%.
- The economy is less open.
- The economy is in a recession.
Currently, the Bank of England’s policy interest rate, Bank Rate, is at 0.1%, which can be considered as the effective ZLB. The economy is almost surely in recession with GDP having declined by 2% in the first quarter and all indications are that it will decline even more in the second quarter. As the UK experiences the ZLB and a recession, it seems likely that the multiplier may be larger than normal and that a fiscal stimulus would be particularly effective in the current circumstances.
A large body of research finds that the multiplier tends to be larger in recessions and smaller in expansions. For example, one study estimates spending multipliers to be approximately zero in expansions and as high as 2 or 3 in recessions (Auerbach and Gorodnichenko, 2012).
A study of Germany reports that fiscal spending multipliers are much higher in periods of negative output gap (where demand is less than capacity) but only have a ‘somewhat limited’ effect during periods of positive output gap (Baum and Koester, 2011).
A study of trends in government spending at the US states level estimates that the multiplier is about 3 if labour markets have some slack, compared with about 1.5 if there is no slack (Shoag, 2010).
During the 2008/09 recession, several European countries implemented so-called ‘austerity’ policies to reduce their level of debt. It has been later found that such fiscal contraction had more of a recessionary effect than initially estimated, which suggests larger fiscal multipliers (Blanchard and Leigh, 2013). The implication is that such countries would have been better off delaying their austerity policies to a time when the economy was on a steadier growth path.
A study by the National Institute of Economic and Social Research shows that the multiplier tends to be higher in the presence of liquidity-constrained consumers (Carreras et al, 2016). When consumers are liquidity-constrained, their marginal propensity to consume is higher, which leads to a higher multiplier. Low-income consumers are generally more liquidity-constrained.
One important factor to affect the multiplier is the role of expectations. It can be argued that if the private sector sees fiscal consolidation as a signal that the share of government spending in GDP will continuously be reduced, households will revise their estimates of their permanent income upwards (Giavazzi and Pagano, 1990). In this sense, there could be substitution between private and public consumption and the multiplier is smaller.
Similarly, a study looking at the 1980s experience of some countries finds that in many cases, private consumption increases rather than contracts during periods when the government enacts plans to reduce debt or deficits (Perrotti, 1999).
The consensus among economic researchers is that the fiscal multiplier is higher when short-term interest rates are at or near zero. A series of studies finds that the size of the government purchase multiplier is close to 2 or even larger in that case (Christiano et al, 2011, Woodford, 2011 and Erceg and Lindé, 2014).
When the economy is at the ZLB, monetary policy tends not react to inflationary pressure coming from the fiscal stimulus and the increase in (expected) inflation leads to a drop in real interest rate, which further stimulates demand and thus increases fiscal multipliers.
The result that fiscal policy may be most potent precisely when monetary policy is least effective is a powerful argument for a fiscal stimulus when in a liquidity trap, in which policy rates cease to have any great stimulatory effect.
The multiplier may also depend on the type of government tool used: taxes, transfers, spending or investment. The multiplier for public investment tends to be larger than for other fiscal measures (see, for example, Abiad et al, 2016).
Where can I find out more?
To read an application of fiscal multipliers to the current crisis, you may read Holland and Lenoël (2020), who estimate that emergency measures by the UK government will offset a quarter of the loss of GDP caused by the pandemic.
The Office for Budget Responsibility maintains an excellent website for fiscal data and projections and the National Institute Economic Review regularly examines current fiscal issues. There is also a page devoted to the multiplier at the Vox-EU website.
Does extending jobless benefits help in a recession? Chicago Booth Review reports on evidence from the last recession on the benefits of unemployment insurance in the United States.