A change in fiscal policy has a multiplier effect on economic growth or contraction because an increase or decrease in government spending or a change in tax policy ripples through every major segment of the economy, affecting levels of spending, production, and business investment. The multiplier effect is the disproportionate impact of government spending on the nation's gross domestic product (GDP).
In other words, fiscal policy has a snowball effect. Economists and business strategists attempt to measure the probable size of the multiplier effect in order to estimate the likely impact of an influx of government spending or a change in tax rates.
- A government increases spending or decreases taxes in part to inject more money into the system.
- Such fiscal policy has a multiplier effect. That is, every dollar spent can be expected to cause an increase in the gross domestic product (GDP) by more than a dollar.
- This is due to the sheer momentum created by the policy. Consumers spend more so businesses produce more goods. Businesses have to hire more to produce more goods, so more people have more money to spend on goods.
- The same phenomenon occurs for both government spending increases and tax cuts. Either tends to increase GDP disproportionately.
Understanding the Multiplier Effect
Government spending and tax rates are the two main mechanisms of fiscal policy. Governments can borrow money and spend it on public projects like bridges and highways, or they can return money to the taxpayers via lower tax rates or tax rebates.
In either case, the overall result is an increase in the amount of money in the system. That means increased demand for goods and services, followed by increased production to meet that demand. Increased production requires more hiring, which creates more income to spend on goods and services.
Influencing economic activity via fiscal policy is a core principle of Keynesian economics.
Measuring the Multiplier Effect
The multiplier effect can be any factor greater than 1, except in the rare instances in which it fails. That is, the amount of money that the government injects into the economy will be surpassed by the amount of income it creates in the economy.
If the multiplier effect is 3, it means that each $1 of stimulus will lead to a $3 increase in overall income.
Government stimulus money inevitably goes into increased consumption and spending by both consumers and businesses. Consumers buy more goods. Businesses invest, expand, and hire more workers. Gross domestic product (GDP) rises. Thus, fiscal policy has a multiplier effect.
The expanded Child Tax Credit had a multiplier effect of 1.25 on GDP in the first quarter of 2021, according to an analysis by Moody's Analytics.
When the Multiplier Effect Fails
The multiplier effect is an indicator of the efficiency of fiscal policy. If the government approves a tax cut, that extra money goes straight into consumers' pockets. But stimulus policies are usually a response to adverse economic conditions. Consumers may save the extra money or use it to pay off debt because they feel insecure in their jobs.
If enough people fail to spend the windfall, the fiscal policy of cutting taxes has not had the intended effect on the gross domestic product. That is a symptom of a deflationary environment.
The Monetary Policy Alternative
In this case, policymakers may try to stimulate the economy by using monetary policy rather than fiscal policy.
Monetary policy is controlled by a central bank such as the Federal Reserve rather than by elected government officials. The central bank has the power to loosen or tighten the supply of money, making it cheaper or more expensive to borrow money.
Cheaper money encourages spending, by both consumers and businesses.
Sometimes, it takes a combination of fiscal policy and monetary policy to respond effectively to an economic crisis. That was the case during the 2007-2008 financial crisis when the Federal Reserve, the U.S. Treasury Department, and Congress stepped in to avert an economic meltdown.
The Opposite of the Multiplier Effect
The opposite of the multiplier effect is the phenomenon known as the negative multiplier effect.
That is, a cut in government spending can reduce GDP by a greater degree than the amount saved by the cut. For example, the elimination of a federal program could reduce orders to businesses that supply the government and reduce the number of jobs directly or indirectly funded by government programs.
The businesses produce less and the workers spend less. The result is a negative multiplier effect that has been estimated at -1.3% of GDP.
Why Does Fiscal Policy Have a Multiplier Effect?
Certainly, private companies can cause a multiplier effect. Amazon employs about 950,000 people in its warehouses in cities and towns across the U.S. In each of those communities, new jobs create demand for goods and services, which leads to the creation of new businesses and services to meet the demand.
But no private entity can compare to a government for sheer spending power.
Moody's Analytics examined the multiplier effect of key components of the big stimulus package that was passed to help Americans cope with the economic effects of the COVID-19 pandemic. Moody's assessment found that the expanded Child Tax Credit alone had a multiplier effect of 1.25 on GDP in the first quarter of 2021. The increase in the Supplemental Nutrition Assistance Program boosted GDP by a 1.61 multiplier effect in the same period. Increased defense spending had a 1.24 multiplier effect.
In Which Type of Fiscal Policy Does the Multiplier Effect Play a Role?
Some fiscal policies are more efficient than others. The multiplier effect is an attempt to measure that efficiency.
A government spending program can be less effective because businesses can't or won't ramp up production and hiring as much as expected, or because increased demand drives up inflation.
In any case, a debate over government spending is never purely about the multiplier effect. It's a political and social debate as well.
It is quite possible, for instance, that a tax cut for the richest 10% would have the same multiplier effect as a tax credit for middle-class and lower-income parents of young children if both proposed policies cost the same. Both mean additional demand for goods and services and increased business investment to meet that demand.
The debate at this point will be about the appropriate use of government money and the fairness of the tax policy.
What Is the Multiplier Effect in the Keynesian Model?
The influential economist John Maynard Keynes introduced the concept of the multiplier effect in his 1936 book, "The General Theory of Employment, Interest, and Money."
Keynes asserted that government spending would inevitably have a multiplier effect no matter what it was spent on. The government could build a dam, fill in a swamp, or just toss money out of the windows on Capitol Hill and the effect would be the same: more money in the economy would create even more money in the economy.
That theory has been somewhat countered by other economists who point out that more government spending means higher taxes to pay for it. And higher taxes must cut into the multiplier effect by limiting spending.