Multipliers and the effectiveness of government policies

UHERO BLOGS ARE CIRCULATED TO STIMULATE DISCUSSION AND CRITICAL COMMENT. THE VIEWS EXPRESSED ARE THOSE OF THE INDIVIDUAL AUTHORS.

By Byron Gangnes, Rachel Inafuku, and Peter Fuleky

The economic shutdown in Hawaii and elsewhere due to the novel coronavirus has led to sharp reductions in employment and private spending, as well as historically large government fiscal responses. Analysis of the effects of changes in government spending and employment policies requires estimates of how much total economic activity will change as a result of the policy. 

Fiscal policy actions have both direct and indirect effects on the economy. The direct effect comes from the increase in demand from the spending itself, or the direct maintenance of employment and income. These direct effects, by raising income and wealth, induce additional spending on goods and services throughout the economy and raise economic activity further. The total impact of both direct and indirect effects is often summarized by fiscal policy multipliers that give the total change in some measure of economic activity per dollar of government spending change. 

Estimates of fiscal policy multipliers go back many years, but there was a resurgence of interest during the Great Recession of 2008-2009 and the subsequent recovery. In its advocacy for the 2009 American Recovery and Reinvestment Act, the Obama Administration relied on a multiplier estimate of 1.5, meaning that every $1 of fiscal support would result in a $1.50 increase in real Gross Domestic Product, once indirect effects were felt. This estimate, while well within the range of the existing literature, came under harsh criticism in some quarters, where skeptics insisted that spending by the government could “crowd out” at least as much private sector activity through the adverse effects of increased government borrowing and competition for limited resources. 

The debate over multipliers is not surprising, considering the difficulty involved in measuring the effect of a policy change in an economic environment that is rapidly evolving for many other reasons. Over the years, researchers have used a variety of methods to identify and estimate the size of multipliers, including structural econometric models that represent the economy in detail; less structural statistical models; analyses that study the performance of the economy after specific past episodes of policy change; and studies that look at variation in state-level policies. It is safe to say that the resulting range of multiplier estimates is quite large, ranging from slightly negative to 3 or higher. 

By our reading and previous modeling experience, we believe the most plausible value for a federal spending multiplier lies above 1 but not more than 2. There is a fairly general consensus that multiplier effects are larger during deep recessions, when private sector activity is weak, and that they depend on the specific type of policy implemented and factors such as business and consumer confidence.

How large is the multiplier in the UHERO econometric model for an increase in government spending here? Recent computations yield a response of about 1.5, consistent with the range of national and state-level studies. Given the severity of the economic downturn, this may well underestimate the true impact at present. That means every dollar of federal spending that comes here has a substantial positive overall economic impact. It also means that any large cuts to federal or state spending would have large adverse impacts, as well. 

For further reading see:

Adams, F. Gerard and Byron Gangnes, Why Hasn’t the US Economic Stimulus Been More Effective? The Debate on Tax and Expenditure Multipliers. World Economics, Vol. 11, No. 4, October-December 2010, pp. 111-130.

Adams, F. Gerard and Byron Gangnes, The Employment Effects of Fiscal Policy: How Costly Are ARRA Jobs? The Journal of Econometric Study of Northeast Asia, Vol. 8, No. 2, August 2012, pp. 1-17.

Ramey, V., Can Government Purchases Stimulate the Economy? Journal of Economic Literature, Vol. 49, No. 3, 2011, pp. 673–685.

Shoag, Daniel. “Using State Pension Shocks to Estimate Fiscal Multipliers since the Great Recession.” The American Economic Review, vol. 103, no. 3, 2013, pp. 121–124.

Whalen, C.J. and Reichling, F., The Fiscal Multiplier and Economic Policy Analysis in the United States. Contemporary Economic Policy, Vol. 33, 2015, pp. 735-746.

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7 thoughts on “Multipliers and the effectiveness of government policies”

  1. Colleen Sathre

    Thanks, very much enjoyed the above blog on the multiplier effect of government spending here. It brought back memories of working with Jim Mak on UH multiplier effects on the Hawaii economy. He did all of the hard work, I just tried to share it with others. Continue to appreciate the good work of UHERO. Best to Jim and all! No need to publish this comment.
    Colleen O. Sathre
    Vice President Emeritus
    Planning and Policy
    University of Hawaii

  2. I am surprised at the similarity apparently found between the size of the multipliers for state and federal spending. The standard analysis indicates that fiscal policy is an ineffective tool for a small open economy with a fixed exchange rate.

    1. Don,

      Yes, we would generally expect the multiplier to be smaller for a very open economy than for one that has fewer trade and other links to the rest of the world, because more of a spending or income increase “leaks out” in spending on imports. Certainly Hawaii fits the bill. However, it’s important to remember that a lot of what we spend money on is services, not merchandise, everything from restaurant meals to Dr. visits. Much of the value of these remains in the local economy.

      On the exchange rate issue, I think the opposite is true. Fiscal policy impacts are generally thought to be larger under fixed exchanges rates because under floating rates the exchange rate tends to appreciate under a demand stimulus, limiting the net effect.

  3. I’ll be the token heterodox and ask a couple heterodox questions:

    How is monetary offset accounted for (if at all) in UHERO’s econometric model? Briefly reading the papers listed, it doesn’t look like any of them model central bank activity or just refer to the ZLB as a supposed constraint. The end of ARRA stimulus, sequester, and tax increases in 2013 was widely hailed as the beginning of another recession, yet none occurred primarily due to monetary policy. This would also seem particularly relevant today given the Fed’s moves outside of standard OMOs and rate reductions.

    Like other multiplier assertions and modeling, public choice considerations are only briefly discussed or not discussed at all. Especially for our state, are you really confident in assuming a high probability that the members of the Executive and Legislative branches can direct funds in focused and timely ways? The last paragraph of the post gets pretty close to the bury-pots-of-money caricature of fiscal stimulus or Bastiat’s broken window fallacy, assuming that any dollar injected (lost) will have positive (negative) impacts no matter what it’s spent on or why.

    1. Laron, Thanks for taking a heterodox position! Of course the first is not really heterodox, but asks whether the expansionary monetary policy by the Fed—which they are saying will continue for some time—might offset any contractionary effect once federal fiscal support is withdrawn. Sure. One of our concerns is that Hawaii is being hit much harder than other states. The Fed sets a one-size-fits-all policy for the US, which may not be as expansionary as necessary for the hardest hit states. For that reason, worrying about fiscal policy impacts may be more important here than in less-affected states.

      Your point about the timeliness and appropriateness of the policy response is an important one. We saw with the ARRA in 2009-2011 that in fact it was difficult to get government spending out in a timely fashion, and that could be a problem this time, too. But to the extent that the spending is directly provided to households through stimulus checks or by maintaining employment, the implementation and effectiveness is direct and rapid. One would hope that funds channeled through existing programs would also be fast, but we have seen with the unemployment insurance delays that this can be a problem.

      On the last point, I would say two things: One reason to think that the multiplier effects in the current environment will be large is that a considerable fraction of the funds are or would be going to support incomes of households with low-to-moderate incomes. Those households tend to spend every dollar they receive. But of course I would not claim that it is irrelevant what it is spent on. For example, money directed to capital investment has a large long-term impact; the problem is that because of delays it has a very weak short-term impact. In the current environment of a very sharp immediate downturn, getting money directly into the hands of households is the primary need.

      1. Mahalos for replying! (Wish this site would send a notification or something when that happens.)

        The recent debacle with UI was definitely on my mind wrt any fiscal efforts. I know you and your coauthors acknowledge this constraint in the linked papers so I just wanted to highlight that any prior beliefs people may have for HI state capacity/effectiveness should probably be updated… and probably not towards greater confidence in state leaders/agencies doing better than expected.

        Getting away from public choice, I hear what you’re saying about the short run multiplier effects and lower income individual’s MPC, and the econometric analysis with IHS’ model and others helps to cement those points. But those model’s are built on, and used within, a New Keynesian framework, no? So AFAIK the 1,400-ish variables don’t capture short and long run costs associated with preventing labor and capital reallocation nor the opportunity cost of fiscal (or monetary) stimulus. A rejoinder to this that I often see and respect is that, by providing stimulus directly to consumers, they’re free to spend as they wish and resources will be reallocated accordingly to meet consumer demand while giving help to those in need. While defensible, this ignores Say’s law and forces a discussion regarding why fiscal stimulus is preferable to immediately removing/suspending frictions that prevent or hinder production and hiring (occupational licensing, housing/zoning regs, commercial permitting, etc.)? End result is the same, but IMHO the latter contains fewer short and long run fiscal and opportunity costs.

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