How do fiscal multipliers vary across different contexts and scenarios?

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Fiscal multipliers measure how much an increase or decrease in government spending affects the overall output and income of an economy. They are important tools for evaluating the effectiveness and sustainability of fiscal policy and budget deficits. However, fiscal multipliers are not fixed or constant. They can vary significantly across different contexts and scenarios, depending on various factors such as the state of the economy, the type of spending, the monetary policy stance, and the openness of the economy. In this article, you will learn how these factors influence fiscal multipliers and why they matter for macroeconomic analysis and policy making.

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Targeted spending:

Allocating funds strategically to sectors like infrastructure or education can maximize fiscal multipliers. This smart investment approach sparks immediate economic activity and seeds long-term growth.
Align fiscal and monetary policies:

Coordinating government spending with monetary policy helps manage inflation and promotes economic stability. Ensuring they work in tandem can be a balancing act but is crucial for effective economic management.

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Zachary Toner

Global Head of Automation | AI Strategy…

1 State of the economy

One of the main factors that affect fiscal multipliers is the state of the economy, or the level of output gap and unemployment. Generally, fiscal multipliers tend to be larger when the economy is operating below its potential, or when there is a negative output gap and high unemployment. This is because in such situations, there is more spare capacity and idle resources that can be mobilized by government spending, and less crowding out of private demand and investment. On the other hand, when the economy is operating at or above its potential, or when there is a positive output gap and low unemployment, fiscal multipliers tend to be smaller, as government spending may compete with private demand and investment, and generate inflationary pressures and higher interest rates.

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2 Type of spending

Another factor that affects fiscal multipliers is the type of spending, or the composition and quality of government expenditures. Generally, fiscal multipliers tend to be larger for spending that has a direct and immediate impact on aggregate demand, such as transfers, subsidies, and public consumption, especially on goods and services that have a high marginal propensity to consume. On the other hand, fiscal multipliers tend to be smaller for spending that has a more indirect and delayed impact on aggregate demand, such as public investment, especially on projects that have a long gestation period and uncertain returns. However, public investment may also have positive effects on long-term growth and productivity, which can increase the potential output and income of the economy in the future.

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Joseph Charitopoulos

Statistics and IT for Operational Risk Control and Information Dissemination Strategy
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How do public investments lead to positive effects on long-term growth and productivity? It is not market factors accounted for the investment, it is government or institutional (see EU) objectives. For instance, the Greek infrastructure roads financed by EU were focused on German vehicle production rather than cheap and sustainable transport, say railways. The latter killed the economy... Add to that the "Green Revolution" agenda, when the Greek government taxed (tariffs) cars coming from EU because of environmental reasons! (to subsidise EV taxis for tourism ESG and not nation-wide growth) Concentration to urban areas became a one-way street, allowing Deloittes to find cheap labour, trained using taxpayer money

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3 Monetary policy stance

Another factor that affects fiscal multipliers is the monetary policy stance, or the level and direction of interest rates and money supply. Generally, fiscal multipliers tend to be larger when the monetary policy is accommodative, or when interest rates are low and money supply is loose. This is because in such situations, monetary policy can complement and reinforce fiscal policy by stimulating private demand and investment, and reducing the cost of borrowing and servicing debt. On the other hand, fiscal multipliers tend to be smaller when the monetary policy is restrictive, or when interest rates are high and money supply is tight. This is because in such situations, monetary policy can counteract and offset fiscal policy by dampening private demand and investment, and increasing the cost of borrowing and servicing debt.

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Joseph Charitopoulos

Statistics and IT for Operational Risk Control and Information Dissemination Strategy
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Government spending during high liquidity periods (see Greece entering the Eurozone; openness of the economy as well), altered the structure of the Greek economy. Demand-driven growth (debt-infused, see Covid globally), drive private investments in intermediaries/importers (SE Asian goods), and not the production of new products by SMEs (small businesses). Whatever comes up, by government-backed money, is doomed to come down... when liquidity is restricted (see all the crises that were preceded by interest rate increases). Government spending, once began, is difficult to stop (prospect theory) because of its political cost

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Zachary Toner

Global Head of Automation | AI Strategy Leader | IT Infrastructure Specialist
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In 2024, fiscal multipliers face unique challenges given the current monetary policy environment. With interest rates high and a tight money supply, fiscal policy's effectiveness is markedly different from periods when monetary conditions are more accommodative. In such a restrictive monetary setting, fiscal multipliers are generally smaller, as high borrowing costs and limited liquidity dampen the impact of fiscal stimulus on private demand and investment. This scenario contrasts sharply with previous periods under more supportive monetary policies, illustrating how fiscal effectiveness can vary significantly based on the prevailing economic context.

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4 Openness of the economy

Another factor that affects fiscal multipliers is the openness of the economy, or the degree of trade and financial integration with the rest of the world. Generally, fiscal multipliers tend to be larger for closed economies, or economies that have low trade and financial flows with other countries. This is because in such situations, government spending can have a more direct and concentrated effect on domestic output and income, and less leakage to foreign demand and savings. On the other hand, fiscal multipliers tend to be smaller for open economies, or economies that have high trade and financial flows with other countries. This is because in such situations, government spending can have a more indirect and diluted effect on domestic output and income, and more leakage to foreign demand and savings.

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Joseph Charitopoulos

Statistics and IT for Operational Risk Control and Information Dissemination Strategy
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It is not only that the FED (US central bank) is exporting printed dollars to import goods and raw materials, it is its leading role in global central banking game theory, as a leader, that makes other big central banks (laggards: UK, JAPAN, Europe) to follow through. As such, the fastest-growing economy in the fastest period of global debt growth (China), is expected to enter a massive financial bubble backed by unstable demand (as explained above) for its output.

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5 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Zachary Toner

Global Head of Automation | AI Strategy Leader | IT Infrastructure Specialist
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Specifically in the US you can consider the overarching goal of controlling inflation, an area where the current administration had created significant challenges. Fiscal measures, ideally, should counterbalance inflation without stifling economic growth. However, with the restrictive monetary stance since Biden received office, fiscal interventions struggle to gain traction. This is a stark departure from previous strategies that might have allowed for more aggressive fiscal policies to stimulate the economy without exacerbating inflationary pressures. The government's struggle to effectively manage inflation through fiscal levers highlights the complexity of aligning fiscal and monetary policies to ensure economic stability and growth.

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How do fiscal multipliers vary across different contexts and scenarios?

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1 State of the economy

2 Type of spending

3 Monetary policy stance

4 Openness of the economy

5 Here’s what else to consider

Macroeconomics

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