Perspective of Fiscal Multiplier

Though we are in amidst of a severe financial turmoil, but this gives us opportunity to learn the working of various concepts of macroeconomics in reality , which we have always studied in books. One of such interesting concept which strikes my mind recently was how is fiscal multiplier working when governments of all countries are resorting to massive bailouts.

Let’s first have a brief look on concept of fiscal multipliers:
According to Wikipedia Fiscal Policy Multiplier refers to the idea that the initial amount of money spent by government leads to an even greater increase in national income. In other words an initial change in aggregate demand causes a change in aggregate output for the output that is multiple of the initial change.

In view of government bailouts, where government is trying hard to provide stimulus to their respective economies in order to increase aggregate demand, we need to analyze role of these fiscal multipliers.

As we know major fiscal policy instruments are government spending and taxation, which impact aggregate demand, resource allocation and income distribution. In current slowdown when worldwide governments are resorting to excessive government spending in order to raise demand, multiplier effects of spending on economic output turns out to be small.

First lets analyze the case where fiscal multiplier is 1, what does this imply- this simply means that an increase of one unit in government spending will lead to an increase by one unit in real gross domestic products (GDP) .Therefore , added public goods are provided free of cost to the society. This outcome is no magic but optimal utilization of resources like labor and capital, which add to production of more good and services.

If multiplier is greater than 1 , ( multipliers via government spending range usually between 1.5 to 2 ) in this gross domestic product rises more than government expenditure. Thus we have additional goods and services which give the room for to raise private consumption and investment.

Historic view
We all know about the great depression of 1930’s, it was the time when the Keynesian tonic was applied to the much damaged US economy. It is much evident from past experience that government spending is linked to overall business fluctuations in the economy. In times of World War II enormous fiscal expansion was done in terms of increased defense expenditure, which led to freedom of global economy from grip of great depression. This in turn proves the existence of large multipliers.

But going by studies of economists some flaws of Keynesian theory come to highlight. According to them the increase of US defense expenditure led to a large multiplier of 0.8.However if we analyze it the other way round, it gives us a very practical and real picture. Accordingly, the increase in war expenditure led to erosion in other components which comprises the GDP. There was massive down surge witnessed in private investment, nonmilitary government expenditure, and net exports. This resulted in a depressive effect rather than a multiplier effect. However in times of peace increase in government expenditure had led to large multipliers. All growth from 1941 to 1945 cannot be attributed to military outlays, many economists believe that multiplier during peace time was significantly different from zero.

Current scenario
The major question comes back to the current crisis, with global economy facing a severe downtrend; will government stimulus lead to large multipliers?

If we compare American economy of 2001 with today we will get a much clearer picture. In 2001 though economy was in recession but at that time there was room for households to use their tax cuts as down payment for car or cover their costs of mortgage refinance.

In current phase credit markets are bruised badly, therefore financial institutions won’t be able to take advantage of income generated by increased government spending to the same extent leading to much smaller multipliers.