Fiscal Multiplier

The fiscal multiplier is the ratio of a country's additional national income to the initial boost in spending that led to that extra income. 

The fiscal multiplier is a Keynesian idea first proposed by John Maynard Keynes' student Richard Kahn in a 1931 paper. It rests on the idea of marginal propensity to consume (MRC): the portion of an additional sum of income a person, household or society will spend rather than save. So long as a country's overall MRC is greater than zero, the theory goes, an initial infusion of government spending will lead to a 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 than the amount of extra spending.

For example, say that a national government enacts a $1 billion fiscal stimulus and that its consumers' MRC is 0.75. Consumers who receive the initial $1 billion will save $250 million and spend $750 million, effectively initiating another, smaller round of stimulus. The recipients of that $750 million will spend $562.5 million, and so on. 

The total change in national income is the initial increase in government or "autonomous" spending, times the fiscal multiplier, which is in turn equal to:

Fiscal Multiplier = 1 / (1 – MPC)

In the example above, the marginal propensity to consume is 0.75, yielding a fiscal multiplier of 4. Keynesian theory would therefore predict an overall boost to national income of $4 billion as a result of the initial $1 billion fiscal stimulus.

Empirical evidence suggests that the actual relationship between spending and growth is messier than theory would suggest. Not all members of society have the same MPC: lower-income households tend to spend a much greater share of a windfall than higher-income ones, for example. MPC also depends on the form in which fiscal stimulus is received. Different policies can therefore have drastically different fiscal multipliers.

In 2008 Mark Zandi, then chief economist of Moody's Economy.com, estimated the following fiscal multipliers for different policy options, expressed as the one-year dollar increase in real gross domestic product (GDP) per dollar increase in spending or decrease in federal tax revenue:

By far the most effective policy options, according to this analysis, are temporarily increasing food stamps (1.73) and extending unemployment insurance benefits (1.64). Both of these policies target groups with low incomes and, as a result, high marginal propensities to consume. Permanent tax cuts benefiting mostly higher-income households, by contrast, have fiscal multipliers below 1: for every dollar "spent" (given up in tax revenue), only a few cents are added to real GDP. 

The idea of the fiscal multiplier has seen its influence on policy wax and wane. Keynesian theory was extremely influential into the 1960s, but a period of stagflation – which Keynesians were largely unable to explain – caused faith in fiscal stimulus to wane. Beginning in the 1970s many policymakers began to favor monetarist policies, believing that regulating the money supply was at least as effective as as government spending. Following the 2008 financial crisis, however, the fiscal multiplier has regained some of its lost popularity: the U.S., which invested heavily in fiscal stimulus, saw a quicker and sturdier recovery than Europe, where bailouts were preconditioned on fiscal austerity.