The theory seems intuitive enough – if government spends money on a major infrastructure project, it is logical that the income received will be spent and fed through to other parts of the economy, and as a result lead to a rise in national income that is a multiple of the initial injection. Most economists would not disagree with this base analysis, but where they do disagree is on the size of the multiplier effect and therefore whether this is the best way to smooth out shortterm fluctuations in economic activity. There has been a considerable amount of research into the size of fiscal or government expenditure multipliers – the change in output that arises as a result of a change in government expenditure.
Does the size of the fiscal multiplier matter? The difference in the estimates of the size of the fiscal multiplier, according to two leading macroeconomists, is revealing. Robert Barro, a Harvard professor, wrote in 2009 that the size of the fiscal multiplier in peacetime was close to zero; Christine Romer, a professor of economics at the University of California, Berkeley, and a former chair of Economic Advisors to President Obama, suggested that the multiplier was nearer to 1.6. When the US government passed a stimulus package of $787 billion (€692 billion) in 2009, the difference in the number of jobs created of these two estimates of the multiplier effects would be around 3.75 million according to three economists, Mendoza, Vegh and Ilzetzki, in an IMF working paper.

What the research does seem to show is that the size of the fiscal multiplier is dependent on a wide range of factors. The fiscal multiplier might be different in developed and less developed countries, whether the government spending ‘shock’ is anticipated or unanticipated, how open the economy is, the exchange rate regime used by the country (whether exchange rates are fixed against other currencies, managed, or allowed to float freely in response to market conditions), whether the economy is experiencing a financial or debt crisis, and the time preferences of the population of a country. Time preferences refer to how people react to the fiscal stimulus; if a government cuts taxes or increases spending, what proportion of the increase in income would be spent and what proportion saved?
To what extent would people build into their decision-making the expectation that a ‘windfall’ now will ‘inevitably’
lead to tax rises in the future? The idea that people will save most of any increase in government spending because they expect to have to pay higher taxes in the future is called Ricardian Equivalence and was initially developed by David Ricardo in the nineteenth century but has been refined somewhat by Robert Barro.
The size of the fiscal multiplier will depend in part, therefore, on the extent to which consumers are Ricardian in their response.
A discussion paper written by Gilberto Marcheggiano and David Miles (Bank of England External MPC Discussion Paper no. 39, January 2013) noted that ‘Empirical studies … face great challenges in measuring multipliers because of the difficulties of identifying exogenous fiscal shocks and controlling for other factors that might affect output responses.’ They further note that studies on the size of fiscal multipliers include estimates between 1.2 and 1.8 and in other cases, 0.8 to 1.5.

Critical Thinking Questions
1 How do you think the size of the fiscal multiplier would vary when a government announced an increase in spending of €50 billion to be spent on infrastructure projects, compared to a cut in income taxes which would put an equivalent amount into people’s pockets?
2 Why do you think that Barro and Romer have such a different view of the size of the fiscal multiplier?
3 Why might the size of the fiscal multiplier depend on whether it is anticipated or unanticipated?
4 The size of the fiscal multiplier will depend on Ricardian Equivalence. To what extent do you think people adjust their spending decisions in response to expectations of future tax changes?
5 If it is difficult to empirically arrive at a reliable and accurate measure of the size of fiscal multipliers, does this mean that policymakers should avoid resorting to the use of fiscal policy as a means of stimulating an economy?
Justify your answer.