A change in fiscal policy has a multiplier effect on the economy because fiscal policy affects spending, consumption, and investment levels in the economy. The multiplier effect is the amount that additional government spending affects income levels in the country.
The two major mechanisms of fiscal policy are tax rates and government spending. Typically, fiscal policy is used when the government seeks to stimulate the economy. Governments borrow money to spend on projects or return money to taxpayers via lower tax rates or tax rebates. The overall effect on the economy is the same as when the government seeks to target and improve aggregate demand. Influencing economic outcomes via fiscal policy is considered Keynesian economics.
The Multiplier Effect
The multiplier effect determines the efficacy of expansionary fiscal policy. If people simply save the money because of poor economic conditions or a desire to repair household balance sheets, there is no effect on the gross domestic product. This is a symptom of a deflationary environment. In this case, policymakers may choose monetary policy to stimulate the economy instead of fiscal policy. Outside of extreme circumstances, the multiplier effect is greater than 1.
If the multiplier effect is 3, it means that each $1 of stimulus will lead to $3 in income. This type of effect is due to increased demand that results in increased consumption and spending. This encourages businesses to invest, expand and hire additional workers, which has ameliorative effects on income and gross domestic product. In turn, increasing incomes and economic activity also leads to more spending and consumption. Thus, fiscal policy has a multiplier effect.