Multiplier

2.0 The fiscal policy multiplier in good and bad times. It is crucial to the arguments of those opposing austerity that the fiscal policy multiplier is reasonably large, or at least can be expected to be large in current economic circumstances. And indeed there are some recent papers which do argue for a large multiplier: for example, s estimate a multiplier of nearly 3 for tax changes and hristiano et al. !20""# suggest that a go$ernment%spending multiplier of 3.& might be plausible in a constant interest rate en$ironment. 'owe$er, a crucial (uestion is whether these multipliers are large in times of high !and)or rapidly rising# public sector debt, and there is e$idence that in such times fiscal policy multipliers may  be much lower and could indeed be negati$e. This is the message of *erotti !"+++#, who argues that the effects of fiscal policy in good times- !i.e. low debt# may be $ery different from its effects in bad times- !i.e. high debt#. Ilet/i et al. !20"0# present e$idence that the fiscal multiplier is ero in countries with debt%1* ratios abo$e 0 per cent. It has in fact e$en been suggested that fiscal contraction may be expansionary: ia$ai and *agano !"++0# argue that thee fi th fisc scal al co cons nsol olid idat atio ions ns un unde dert rta/ a/en en by bo both th Ir Irel elan and d an and d 1e 1enm nmar ar/ / in th thee "+ "+0s 0s we were re expansionary. There is also e$idence !see 4einhart and 4ogoff, 20"0# that in countries with debt% 1* ratios greater than +0 per cent economic performance deteriorates sharply. The (uestion that arises, of course, is why low and possibly negati$e fiscal policy multipliers may occur wit with h hig high h publ public ic sec sector tor debt. The mai main n mec mechani hanism sm in the li liter teratu ature re !se !see, e, e.g. 5utherland, "++&# is somewhat as follows. 5uppose a country is experiencing a rapidly rising  public debt which is unsustainable. u nsustainable. 5ome consolidation is necessary6 n ecessary6 the only (uestion is when will it be introduced7 The longer the delay in introducing the policy, the more painful it will be. The sudden introduction of a fiscal consolidation programme remo$es the uncertainty about when it will be introduced and means that it is less painful than expected, and for both these

reasons it is expansionary. 'owe$er, there is a complementary explanation for how a fiscal consolidation programme can be expansionary: the programme reduces the budget deficit o$er a number of years, so at the end of the programme, the stoc/ of public debt is considerably lower  than it otherwise would ha$e been. If the debt ta/es the form mainly of long%term go$ernment  bonds, and assuming that these bonds are imperfect substitutes for other assets, including shorter  term bonds, the lower supply of such bonds means their price will be higher, and hence their  yield will be lower. 5o future long%term interest rates will be lower than they otherwise would ha$e been and with foresight current long%term interest rates will be lower as well. 5o the policy wor/s by reducing current and expected long%term interest rates6 it does this gi$en the time path of expected short%term rates, meaning it reduces the term premium on go$ernment bonds. 8ower  long%term interest rates may increase both consumption and in$estment spending as suggested by the textboo/s. They may well mean higher asset prices, and these may stimulate spending in a $ariety of ways. 'igher share prices may stimulate consumption spending through a wealth effect and in$estment spending by ma/ing it easier for firms to raise e(uity capital. An increase in asset $alues may strengthen firms- balance sheets, and this may encourage ban/ lending. *erhaps most importantly, it may result in a depreciation of the exchange rate !it raises the price of foreign currency, another asset#, and this may stimulate demand by raising exports and shifting domestic spending from imports to domestic goods. 5o, there are a number of ways in which a fiscal consolidation programme may raise spending through reducing longer term interest rates. 9or the o$erall policy to be expansionary, it is necessary that these indirect effects outweigh the direct effects of the policy. f course, e$en if they do not completely offset these expansionary forces, they may offset them partially and ma/e the contraction less se$ere than it otherwise would ha$e been.

A recent I;9 study !I;9 20"0# has sometimes been cited as e$idence that fiscal consolidation is contractionary6 the main finding is that a fiscal consolidation e(ual to " percent of 1* typically reduces 1* by about 0.< percent within two years- !op. cit., p. +=#. >ut this article does not contend that fiscal contraction is ne$er contractionary. Indeed, the e$idence is o$erwhelming that on a$erage fiscal contraction is contractionary. 4ather, the contention is that when there is a problem- with the public sector debt, the fiscal policy multiplier may well be much smaller than on a$erage and could possibly be negati$e.