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Re-thinking Fiscal Multipliers

Raj Nallari's picture

Keynes is best known for suggesting fiscal stimulus policies and programs to increase aggregate demand to get out of a deep recession. Since the marginal propensity to consume is positive and less than one; the bigger it is, the larger the fiscal multipliers will be and the faster we will get out of a recession. Conventional Keynesian multipliers are meant for closed economies (no leakages from demand through imports and the effect of the fiscal expansion on the exchange rate further reduced multiplier) and do not consider the total debt position of the country. More generally, the fiscal multipliers of an expansionary fiscal policy will be bigger if the leakages are minimized, an accommodative monetary policy is implemented, and the fiscal position of the country is sustainable after the initial change in fiscal policy. Historically, multipliers on government spending are estimated to be in the range of 1.5 to 2, while tax-cut multipliers can be much smaller, say 0.5 to 1.

But the world is a drastically changed place, particularly during this global crisis, ant the various multipliers are likely to be much smaller because of leakages in a globalized world in the form of higher imports from rest of the world. Also, the various multipliers may work at cross purposes and the cumulative effect may be much smaller as shown in Vegh et al. (2009). The full effect of fiscal policy multipliers in the first round is smaller in models that incorporate a sensitivity of the private investment to the interest rate. Public investment might crowd-out private investment in implementation of fiscal stimulus packages. The crowding-out is the result of an expansionary fiscal policy causing the interest rates to increase and thereby reducing the private investment as financing becomes expensive.

The main challenges in estimating the size of multipliers relate to identification and attribution problems as well as the structure of the model used in the estimation process. Fiscal policy is usually deployed with other policies and many factors come into play at the same time. Moreover, the impact of fiscal policy can be felt over many years by which time other policies and factors may have changed as well. There is a long literature on the empirics of multipliers, particularly for advanced economies. Focusing on recent studies, one could summarize that:

  1. In recessions, government spending rather than tax-cuts has to do “the heavy lifting”1 as historically, multipliers on government spending are estimated to be in the range of 1.5 to 2, while multipliers for tax cuts can be much smaller, say 0.5 to 1. However, Taylor (2008) points out that the 2008 May tax rebates of $300-600 per person by the Bush administration did not avert an economic recession in the fourth quarters of 2008. The small and insignificant effect of tax rebates in 2001 and 2008 conforms to the permanent income and life-cycle theories of consumption in which temporary increases in income are predicted to lead to small increases in consumption.
  2. In contrast, Moody’s model indicated that multiplier for low-income and liquidity-constrained consumers is 1.73 for unemployment benefits, and 1.64 for food stamps, and 1.36 when money is transferred to the states.
  3. Fiscal multipliers vary widely across countries and decreased over time and spending multipliers are estimated to be in the range of zero to two (Bryant and others 1988). In Vegh et al. (2009) fiscal multipliers tend to be lower for advanced or high income countries than emerging or developing ones; they are bigger for countries following fixed exchange rate regimes than for those adopting flexible regimes and they tend to be bigger for closed economies than open-economies. The main reason is that the more open an economy the higher likelihood of leakages from the domestic economy in the form of spending on imports.
  4. When credit markets are impaired, tax cuts as well as income earned from government spending on goods and services, will not be leveraged by the financial system to nearly the same extent, resulting in (much) smaller multipliers. The conventional IS-MP model fails to deal with ‘dysfunctional financial markets’ or the liquidity trap, a condition that is currently prevalent in many advanced and emerging economies, in which banks are willing to lend only to the ‘safest’ of the borrowers.


As a matter of fact, while the structure of the economy and dynamics behind the multiplier is more complicated than the standard text books indicate, it is crucial to really understand important factors such as the role of housing and stock in households’ wealth and in firms’ balance sheets. Also, understanding credit frictions or lending rates is very important as those rates affect not only firms’ investments but also the optimal monetary policy of any central bank.

The estimates of Vegh et al (2009) shown above explain the so far weak impact of the large US fiscal stimulus package of over $757 billion during 2009, and also explain why the tax-refunds of $150 billion in mid-2008 by the Bush administration did not prevent a US recession in later half of 2008.


1. Feldstein, Martin (January 2009) estimates that the marginal propensity to consume out of disposable income is 0.7, while the marginal propensity to consume out of reduction in taxes and tax rebates is only 0.13.


Submitted by Ugochukwu Agu on
The most recent study I did (though unpublished) for most developing countries in African and few countries from the advanced economies equally reaffirmed IIzeski and Vegh (2009) smaller fiscal multipliers values for advanced countries and larger values for developing economies. For instance Argentina and South Africa had impact employment multipliers of 0.6 and 0.3 respectively, and their long run multipliers were twice that of any of the developed countries. This goes to show that an additional 1% shock to government consumption in Argentina will lead to an increase in employment by 0.6% in the short-run and would lead to an increase in employment by 1.9% in the long-run (peak). Employment multipliers for Italy are 0.09 in the short term and 0.11 in the long term. That means that a 5% increase in government consumption (or €16bn in 2009; 1% of GDP) can lead to a 0.45% increase in employment (or 100,000 more people) in the short-run and to a 0.55% (125,000 more people) increase in employment in the long-run. The potential short-term impact is higher than it would be in France, Germany and United Kingdom

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