Macroeconomics: Multipliers

Here's a little something I did for a macroeconomics course recently:

Macroeconomics: Much ado about multipliers (Sept 24^th 2009) The Economist

Question: What are multipliers, and what are the reasons they may not influence GDP growth as much as politicians hope in the current downturn?

According to US Federal Reserve Chairman Ben Bernake, fiscal policy could have been employed during the 1929 recession to prevent The Great Depression. Furthermore, he believes that fiscal policy was not employed in a manner that would have mitigated the worst effects during the depression. The current economic downturn has warranted a very different response. The US, Canadian, and other countries’ responses worldwide have reacted to the downturn with fiscal policy measures in the form of infrastructure funding, corporate bailouts, and other strategies. This has taken place in true Keynesian fashion with the goal of restoring economic growth. In the US, the $787bn relief effort is primarily in the form of infrastructure spending and multi-billion dollar bailouts as part of the Troubled Asset Relief Program (TARP). For instance, financial institutions such as the Bank of America and Citigroup were granted $45bn each to prevent them from failing. US politicians and economists have argued fiercely over the efficacy of spending vs. tax cuts and their associated multipliers effects on GDP. In Canada, infrastructure spending is also a large component of the fiscal policy introduced to aid recovery, and tax cuts and incentives have also been introduced. For instance, a tax credit for home renovations is intended to fuel consumer spending and drive employment.

According to Keynes, the effects of fiscal policy initiative on GDP are greater than just the amount of money dedicated. He argues that since GDP is comprised of more than just government spending (GDP = C + I + G + NX), other factors are stimulated by applying government spending and reanimating stalled sectors of the economy. Furthermore, this unleashes a chain of events which proceed with increasing momentum which has a multiplying effect on the government spending in terms of GDP growth.

However, there are several factors that inhibit the multipliers. Firstly, different types of spending have different ranges of multiplier effects. Governments must chose carefully when selecting the type of fiscal policy to apply.

Secondly, government spending can “crowd out” planned private investment and consumption. This can happen in two ways. Consumption and investment may be reduced if the government raises taxes to finance the spending. Alternately, increased interest rates as a result of government spending could restrict the consumption by making it more expensive for consumers to borrow in order to make big purchases. Even the expectation of the increase in taxes or interest rates can influence consumer confidence and slow GDP growth. These effects can be significant enough to actually create a negative multiplier, completely undermining fiscal policy. Interestingly, this does not yet seem to be an issue in Canada. The Bank of Canada recently warned that rising household debt, combined with Government debt, poses a risk to economic recovery, suggesting that Canadians are actually spending above their means. This has the frightening implication that Canadians are not making enough money to make purchases in general, regardless of consumer confidence.

Thirdly, as mentioned in the article, stimulus can “leak” abroad. The US and Canada are relatively open economies. This means that citizens and businesses can import and export goods, participate in financing activities, and consume and sell services abroad. This results in some funds introduced as fiscal stimulus measures spilling across borders. Therefore, the stimulus loses the full impact of the funds in terms of the spending itself and the multiplier.

Lastly, long term effects of the stimulus may erode the multiplier by artificially sustaining companies that should be allowed to fail. For instance, it could be argued that GM and Chrysler should not have been bailed out since they have been producing relatively poor-quality automobiles which are not as fuel efficient as those made by competitors. Saving them thwarts the Shumpeterian notion of creative-destruction and does not allow innovative companies to take their place and thrive. Furthermore, some economists argue that subsidies in general erode long-term competitiveness. Thus, bailouts and subsidies may reduce the impact of multipliers in the long run.

In addition to the factors listed above which may reduce multipliers, another reason that causes concern to politicians is the fact that the effects of fiscal policy and the magnitude of multipliers are difficult to predict. This is partly because of the nature of macroeconomics in general: Externalities and changing parameters make ceteris paribus assumptions impossible. Forces at play in any macroeconomic event will always be different for similar events, making even general quantitative predictions difficult, and leads economists to the answer “it depends” in many cases. For example, historic evidence about types of multipliers is largely based on military spending, but most policies in place in the current downturn are based on infrastructure spending. Furthermore, since interest rates have been near zero in the US and Canada for the last several months, lowering interest rates as a Keynesian response is not an option. This results in further crowding-out.

In conclusion, multipliers are effects that cause fiscal policy measures to have greater impacts on GDP growth then the stimulus alone. However, factors such as differing efficacies of policy types, leakage, crowding out, and the thwarting of creative destruction all limit the effect of multipliers.

Table 1: Categories of fiscal policy and associated multiplier ranges (Source: The Atlantic)

Category	Estimated Policy Multiplier
	High	Low
Purchases of Goods and Services by the Federal Government	2.5	1
Transfers to State and Local Governments for Infrastructure	2.5	1
Transfers to State and Local Governments Not for Infrastructure	1.9	0.7
Transfers to Persons	2.2	0.8
One-Time Payments to Retirees	1.2	0.2
Two-Year Tax Cuts for Lower- and Middle- Income People	1.7	0.5
One-Year Tax Cuts for Higher-Income People	0.5	0.1
Extension of First-Time Homebuyer Credit	1	0.2

Figure 1 - Multipliers

Keynesian economics state that increases in tax cuts, low interest rates, and government spending should be applied in a downturn. This results in a rightward shift of the aggregate demand curve (AD – AD1). This shift triggers a multiplier effect that results in more spending, production, investment, which have rebound effects though the economy, resulting in another rightward shift in aggregate demand (AD1 – AD2).The intersections of the short-run aggregate supply curve, the aggregate demand curve after the application of Keynesian policies and the multiplier, and the long-run aggregate supply curve indicate the increase in GDP on the X-axis.

GDP increases as a result of Keynesian Policies and Multipliers

Figure 2 – ‘Crowding-out’ when interest rates cannot be lowered

Under normal market conditions, increases in government spending or tax cuts would result in a rightward shift in IS, corresponding to a higher interest rate (I*), and higher GDP (Y*). A portion of the increase in Y is attributed to the fiscal multiplier. However, in the current economic downturn, interest rates have not increased in accordance with Keynesian economics which dictate that interest rates should be kept low in conjunction with government investments in infrastructure to create a multiplier effect. Because the interest rates are kept low, the shift from Y to Y1on the X-Axis when LM shifts right comes at the expense of consumption and investment (i.e., ‘Crowding-Out’).

‘Crowding-out’ - Keynesian macroeconomic policies and near zero interest-rates