Sep 29 2009

How big is the government spending multiplier in America? Well, it depends on which economist you ask…

Economics focus: Much ado about multipliers | The Economist

What is the goal of fiscal stimulus during a recession? Is it simply to increase nation’s total income by a certain amount determined by how much a government increases its own spending by? If this were the case, then an $800 billion stimulus package, like the one begun this year in the US, would lead to a total increase in national income of, well, exactly $800 billion.

While such an outcome is possible, it is not the desired outcome of the Obama administration and the economists who have supported the use of expansionary fiscal policy during economic downturns (i.e. the Keynesian school of economists). Keynesians expect that an initial increase in government spending (or a decrease in taxes) will result in households and firms increasing their own consumption and investment, meaning successive increases in spending. The initial change in spending ultimately gets multiplied through further rounds of spending. The total change in national income resulting from an initial change in government spending or taxes depends on the size of the fiscal multiplier. Now, this is where things get tricky! From the Economist:

The size of the multiplier is bound to vary according to economic conditions. For an economy operating at full capacity, the fiscal multiplier should be zero. Since there are no spare resources, any increase in government demand would just replace spending elsewhere. But in a recession, when workers and factories lie idle, a fiscal boost can increase overall demand. And if the initial stimulus triggers a cascade of expenditure among consumers and businesses, the multiplier can be well above one.

The above scenario, where an economy is operating below full-employment and government spending puts the nation’s idle resources to work, creates new income and further increases private spending, is precisely what the Obama team and its economists hope will happen in the US economy soon. A multiplier of above one means the $800 billion will ultimately increase America’s national income by something greater than $800 billion!

The multiplier is also likely to vary according to the type of fiscal action. Government spending on building a bridge may have a bigger multiplier than a tax cut if consumers save a portion of their tax windfall. A tax cut targeted at poorer people may have a bigger impact on spending than one for the affluent, since poorer folk tend to spend a higher share of their income.

Crucially, the overall size of the fiscal multiplier also depends on how people react to higher government borrowing. If the government’s actions bolster confidence and revive animal spirits, the multiplier could rise as demand goes up and private investment is “crowded in”. But if interest rates climb in response to government borrowing then some private investment that would otherwise have occurred could get “crowded out”. And if consumers expect higher future taxes in order to finance new government borrowing, they could spend less today. All that would reduce the fiscal multiplier, potentially to below zero.

Herein lies the controversy about the effectiveness of deficit-financed fiscal stimulus. Several posts on this blog have focused on the neo-classical, supply-side economists’ fears that expansionary fiscal policy financed by government borrowing will drive up interest rates to private borrowers, thereby “crowding-out” private investment, off-setting any expansion in output achieved through government spending. In the Keynesian model, however, it is precisely because interest rates have bottomed out at the “zero bound” (according to Paul Krugman) that government borrowing and spending will not lead to crowding-out, rather could actually increase investors’ willingness to spend (their “animal spirits”) on new capital, actually “crowding-in” private investment.

Alas, the debate continues. The ironic thing is that even years from now, after all of Obama’s stimulus money has been spent, and the US economy is either fully recovered or it is not, we still won’t know how large the fiscal multiplier was, since tomorrow’s economists will find it nearly impossible to isolate the variable of the $800 billion of government spending and determine just how much of America’s growth in income can be attributed to government spending, and how much resulted from automatic stabilizers built-in to help the economy recover on its own during recessions.

Discussion Questions:

  1. Why do tax cuts for the rich tend to have a smaller multiplier effect than tax cuts for lower income households?
  2. How can government borrowing drive up interest rates, and why is this a concern to policy makers deciding on the size of a fiscal stimulus package?
  3. What are the animal spirits the article mentions? Where have you heard this expression before?
  4. Do you think borrowing trillions of dollars and spending it to put people back to work and try to dig the US economy out of recession is wise, or should the US government be practicing better fiscal responsibility?

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

9 responses so far

9 Responses to “How big is the government spending multiplier in America? Well, it depends on which economist you ask…”

  1. Bjorn Borgerson 03 Nov 2009 at 5:54 pm

    In low income families, taxes weigh heavily. If we reduce taxes, more members of the families are likley to look for work, as they will have more money left over after tax, and will therefore be more willing (and able) to spend. This higher spending leads to more government revenues from VAT. Those who have a high income have the luxury to save some of their money, and are thus less likley to have a large effect on the multiplyer…

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  2. axelon 05 Nov 2009 at 5:07 am

    Tax cuts for the rich tend to have a smaller multiplier because the rich do not spend as much of their income. but, for the poor since they spend more of their income it significantly changes the amount that they can buy.

    government borrowing drive up interest rates because if the government needs to borrow money then they usually borrow a lot of money, therefore they increase the amount demanded and the rates go up.

    I think that borrowing trillions of dollars and spending it will put people back to work, since it seems like what an entrepreneur has to do. an entrepreneur borrows money to start a business then makes enough money to pay back the loan. just now the government is doing it and people will be paying back by taxes.

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  3. Rusty Knaubon 04 Feb 2010 at 12:21 am

    1. Tax cuts for low income households will have a greater effect on the multiplier because these households spend most of their DI. This is because they cannot afford to save their money and if they see a cut in taxes they are more likely to consume more due to their higher DI. The richer households on the other hand have (as Bjorn mentioned) the luxury to place some of their income into saving accounts and would therefore not differ much in their consumption habits if they had an increase in their DI.

    2. If the government borrows too much then interest rates will be pushed up because the government will have lost a lot of money in it's borrowing of money and will drive up interest rates in order to gain some money back; this could then lead to a "crowding out" in public investment. And this is a concern to policy makers because the bigger the fiscal stimulus package the higher the interest rates will be and the lower public investment will be leading to no output increase.

    3. The animal spirits referred to in this article is in sorts the bare instincts or faith of the people to their government. For example, the Keynesian believe that lower interest rates could revive the faith of the people and drive them to help their government and invest more into new capital. This term was also mentioned in the rap video we watched in class about the Keynesian vs. Classical views on macroeconomics.

    4. I think it's a good idea because government spending has a solid theory which supports that AD should increase and even multiply after a stimulus package is poured into the economy. Also I think it's a better idea than the classical point of view that the government should not do anything because the economy will fix itself…but that could take a while and I feel obliged to quote Keynes's motto "In the long-run we're all dead". Although the economy could self-correct eventually there are too many unemployed people for the government to just sit on its hands and do nothing. If an increase in G leads to an increase in AD in addition to an increase in I + C depending on the multiplier, and with AD shifting out the economy should gradually move towards an equilibrium PL with the NRU or Yfe then why not do it? In my mind there is no doubt that Obama and his team did the right thing.

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  4. Bjorn Kvaaleon 04 Feb 2010 at 2:41 am

    Tax cuts would have a greater effect for low income households because they must spend more of their money on taxes, therefore increasing the multiplier to a greater extent than the richer households. The rich, on the other hand, must pay a greater percentage of taxes, yet they make more money, so they also have some money to save or spend elsewhere. Therefore, they have less of an impact on the multiplier than the poorer households. I think the stimulus package is a good idea overall because it will increase AD in the short run, which will hopefully lead to an increased AD in the long run too. With stability in the short run, maybe the long run can profit from this.

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  5. Andrew McLennaghanon 04 Feb 2010 at 4:05 am

    In families with lower disposable incomes taxes severely affect their decision making on what they need and want. So when their DI increases they can spend the money on what they want and what their need rather than solely paying for their needs. Where as families with higher DI's already have enough money to full fill their wants and needs with out the need to worry about the tax.

    When the Government spends too much then interest rates will raise so that G can get some money back.

    Animal spirits, is the fact that human's are not perfect therefore why nothing in economics can be definitely calculated to the specific person. Because nobody is exactly the same. And I heard this is class yesterday.

    I think this is good because if I remember this is called a stimulus package The whole goal of the stimulus package is to supply AD with a kick which would then restore company's revenue. This is done with the idea that it remains like that so company's start re-employing workers.

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  6. Alexander Elyon 04 Feb 2010 at 8:10 pm

    1. Why do tax cuts for the rich tend to have a smaller multiplier effect than tax cuts for lower income households?

    Lower income people spend a higher percentage of their income than the wealthy, who tend to save more.

    2. How can government borrowing drive up interest rates, and why is this a concern to policy makers deciding on the size of a fiscal stimulus package?

    Governments sell bonds to finance deficit spending. This increase in supply of bonds drives down their price, thus increasing the interest earned on each bond. To compete with the higher return offered by government bonds, private banks must raise interest rates. These higher interest rates decrease the level of investment, a potentially dangerous consequence.

    3. What are the animal spirits the article mentions? Where have you heard this expression before?

    We heard this term in the Keynes vs. Hayek rap video, where Keynes referenced animal spirits. They are the confidence or lack thereof that consumers and investors have. Higher confidence leads to higher investment and consumption, while the opposite is true for lack of confidence.

    4. Do you think borrowing trillions of dollars and spending it to put people back to work and try to dig the US economy out of recession is wise, or should the US government be practicing better fiscal responsibility?

    I believe it is a good idea, because it is the most effective way of driving up demand and restoring confidence. However, repeated and long-term borrowing can bankrupt a government, so restraint is needed to a certain degree.

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  7. [...] How big is the government spending multiplier in America? Well, it depends on which economist you as… [...]

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  8. srmcookon 12 Dec 2011 at 9:58 am

    1. Why do tax cuts for the rich tend to have a smaller multiplier effect than tax cuts for lower income households?

    • The rich tend to make up a much smaller proportion of a national economy, and the average-income households make up the majority of an economy. Therefore, MPC will increase only slightly, because avg. income households will save more money than consume. The rich will consume more, but since they make up a usually very small proportion of an economy, as mentioned, the MPC will increase only slightly, compared to the majority of the population.

    2. How can government borrowing drive up interest rates, and why is this a concern to policy makers deciding on the size of a fiscal stimulus package?

    • The government is competing against the private sector for money, thus driving up interest rates on the money, because it is limited in amount. The reason this concerns policy-makers is because the higher the interest rates, the more money they will have to pay back when they must re-pay the money they borrowed.

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  9. srmcookon 12 Dec 2011 at 9:59 am

    3. What are the animal spirits the article mentions? Where have you heard this expression before?

    • "Animal Spirits" in this article (and generally) refers to consumer confidence. We have heard this expression in a prior assignment when studying Keynes' beliefs.

    4. Do you think borrowing trillions of dollars and spending it to put people back to work and try to dig the US economy out of recession is wise, or should the US government be practicing better fiscal responsibility?

    That depends. Drawing on Keynes' beliefs, expansionary fiscal policy is very often beneficial in stimulating an economy in times of recession; it creates new jobs, puts those unemployed back in jobs/positions, and returns a nation's AD back to regular levels. However, from what we have seen over the last few years in the United States, we can very evidently see that more sophisticated and more appropriate fiscal responsibility and policy is necessary and urgently called for. The next elections, coming up in 2012, will hopefully give us the opportunity to correct the flagrant, misguided, liberal, economic policies followed by the current US Presidential Administration.

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