Fiscal multiplier

A pound of government spending might raise national income by more than a pound, or by less. The fiscal multiplier is the number that decides which.

The fiscal multiplier is the change in national output produced by a unit change in government spending or taxation. If a pound of extra public spending raises GDP by more than a pound, the multiplier exceeds one; if by less, it falls short. Its size is central to whether fiscal stimulus works.

How the multiplier works

The idea is that spending circulates. When the government spends a pound, the recipient earns income, spends part of it, and so passes income to others, who spend in turn. Each round adds to output, so the initial injection can raise total income by a multiple of itself. How big the multiple is depends on how much of each extra pound of income people spend rather than save or send abroad: the more they spend domestically, the larger the multiplier.

Why its size is contested

The multiplier is one of the most disputed numbers in macroeconomics, because it varies enormously with circumstances. It tends to be larger when the economy is depressed, with idle resources and interest rates at their floor, so stimulus does not crowd out private activity. It tends to be smaller, even below one, when the economy is near capacity, when stimulus pushes up interest rates or imports, or when people save the windfall expecting future taxes. Estimates therefore range widely, which is why arguments about stimulus are, at bottom, arguments about the multiplier.

Why it matters for policy

The multiplier is the crux of the case for and against fiscal stimulus. If it is well above one in a slump, government spending can be a powerful and even self-funding way to lift a depressed economy. If it is below one, stimulus buys little extra output for the debt it adds. Getting the multiplier wrong, assuming it is large when it is small, or the reverse, leads to fiscal policy that either wastes resources or misses chances to help.

The fiscal multiplier turns the abstract question of whether government spending helps the economy into a matter of magnitude, and a matter that depends on the state of the economy. Its variability is the reason fiscal policy is so contested: the same action can be powerful medicine in a deep slump and a costly distraction near full capacity.