Fiscal Multipliers – How big or small?

Tyler Cowen points to an interesting paper by Ethan Ilzetzki, Enrique Mendoza, and Carlos Vegh. There are multiple options to read the paper:

Here is a new paper (gated) on fiscal multipliers (shorter, ungated version here, powerpoints here, slides here, ungated but slightly older version here

I read the ungated shorter version (:-)). The authors look at fiscal multipliers across 45 countries (20 developed and 25 developing) and divide these economies further into different types. The findings are:

  • In high income countries, the impact response of output to increases in government spending is larger than in developing countries and considerably more persistent.
  • The degree of exchange rate flexibility is a critical determinant of the size of fiscal multipliers. Economies operating under predetermined exchange rate regimes have long‐run multipliers of around 1.5, but economies with flexible exchange rate regimes have essentially zero multipliers.
  • The degree of openness to trade (measured as exports plus imports as a proportion of GDP) is another critical determinant. Relatively closed economies have long‐run multipliers of around 1.6, but relatively open economies have very small or zero multipliers.
  • In highly-indebted countries, the output response to increases in government spending is short‐lived and much less persistent than in countries with a low debt to GDP ratio.
  • The multipliers for the United States in the post‐1980 period are rather small (in the range 0.3-0.4) both in the short and long-run. On the other hand, multipliers for government investment are large (around 2).

What are the implications for policy?

All in all, our findings suggest that drawing sweeping generalizations on the size of the fiscal multipliers is probably an exercise in futility. Some of our most robust results point to the fact that the size of the fiscal multipliers critically depends on  key characteristics of the economy (closed versus open, predetermined versus flexible exchange rate regimes, high versus low debt) or on the type of aggregate being considered (government consumption versus government investment).

In particular, we have found that, in economies open to trade and operating under flexible exchange rates, a fiscal expansion leads to no significant output gains. Further, any gains will be, at best, short-lived in highly-indebted countries. Since, over the last decades, many emerging countries have become more open to trade  and moved towards greater exchange rate flexibility (typically in the context of inflation targeting regimes), our results suggest that seeking the holy grail of fiscal  stimulus is likely to be counterproductive, with little benefit in terms of output and potential long‐run costs due to larger stocks of public debt.

On the other hand, emerging countries – particularly large economies with some degree of “fear of floating” – would be well served if they stopped pursuing procyclical fiscal policies. Indeed, emerging countries have typically increased government consumption in good times and reduced it in bad times, thus amplifying the underlying business cycle – what Kaminsky, Reinhart, and Vegh (2004) have dubbed the “when it rains, it pours” phenomenon. The inability to save in good times greatly increases the probability that bad times will turn into a full‐fledged fiscal crisis. Given this less than stellar record in fiscal policy, even an a-cyclical fiscal policy – whereby government consumption and tax rates do not respond to the business cycle – would represent a major improvement in macroeconomic policy. While occasional rain may be unavoidable for emerging countries, significant downpours would be relegated to the past.

Interesting paper. Helps think through the fiscal multiplier debate more clearly. And the conclusion is pretty intuitive as well. The size and effectiveness of fiscal multiplier depends on nature of economy.


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