:max_bytes(150000):strip_icc()/GettyImages-144099380-a371880b80d5406f8058befd3e636aa2.jpg)
Investopedia contributors come from a range of backgrounds, and over 24 years there have been thousands of expert writers and editors who have contributed.
Updated November 30, 2022 Fact checked by Fact checked by Kimberly OvercastKimberly Overcast is an award-winning writer and fact-checker. She has ghostwritten political, health, and Christian nonfiction books for several authors, including several New York Times bestsellers. Kimberly also holds a Class C private investigator license.
A change in fiscal policy can result in a multiplier effect throughout an economy.
Any increase or decrease in government spending or changes in tax policy can impact spending, production, and investment, leading to economic growth or contraction. The multiplier effect refers to the disproportionate impact of government spending on a nation's gross domestic product (GDP).
In other words, fiscal policy can snowball. Economists and business strategists attempt to measure the probable size of this multiplier effect in order to estimate the likely impact of changes to government spending or tax rates.
Government spending and tax rates are the two main mechanisms of fiscal policy. Governments can borrow money and spend it on public projects like bridges and highways, or they can return money to the taxpayers via lower tax rates or tax rebates.
In either case, the overall result is an increase in the amount of money in the system. That means increased demand for goods and services, followed by increased production to meet that demand. Increased production requires more hiring, which creates more income to spend on goods and services.
Influencing economic activity via fiscal policy is a core principle of Keynesian economics.
The multiplier effect can be any factor greater than 1, except in the rare instances in which it fails. When the multiplier effect is positive, this means that the amount of money that the government injects into the economy will be surpassed by the amount of income it creates in the economy.
If the multiplier effect is 3, it means that each $1 of stimulus will lead to a $3 increase in overall income.
Government stimulus money inevitably goes into increased consumption and spending by both consumers and businesses. Consumers buy more goods. Businesses invest, expand, and hire more workers. GDP rises. Thus, fiscal policy has a multiplier effect.
The multiplier effect is an indicator of the efficiency of fiscal policy. If the government approves a tax cut, that extra money goes straight into consumers' pockets. But stimulus policies are usually a response to adverse economic conditions. Consumers may save the extra money or use it to pay off debt because they feel insecure in their jobs.
If enough people fail to spend the windfall, the fiscal policy of cutting taxes has not had the intended effect on the GDP. That is a symptom of a deflationary environment.
In this case, policymakers may try to stimulate the economy by using monetary policy rather than fiscal policy.
Monetary policy is controlled by a central bank such as the Federal Reserve rather than by elected government officials. The central bank has the power to loosen or tighten the supply of money, making it cheaper or more expensive to borrow money.
Cheaper money encourages spending, by both consumers and businesses.
Sometimes, it takes a combination of fiscal policy and monetary policy to respond effectively to an economic crisis. That was the case during the 2007-2008 financial crisis when the Federal Reserve, the U.S. Treasury Department, and Congress stepped in to avert an economic meltdown.
The opposite of the multiplier effect is the phenomenon known as the negative multiplier effect.
That is, a cut in government spending can reduce GDP by a greater degree than the amount saved by the cut. For example, the elimination of a federal program could reduce orders to businesses that supply the government and reduce the number of jobs directly or indirectly funded by government programs. The businesses, in turn, produce less and their workers spend less, changes that themselves will ripple throughout an economy.
Certainly, private companies can cause a multiplier effect. Amazon employs about 950,000 people in its warehouses in cities and towns across the U.S. In each of those communities, new jobs create demand for goods and services, which leads to the creation of new businesses and services to meet the demand.
But no private entity can compare to a government for sheer spending power.
In 2021, Moody's Analytics examined the multiplier effect of key components of government spending. Moody's assessment found that an expanded Child Tax Credit alone had a multiplier effect of 1.25 on GDP in the first quarter of 2021; the increase in the Supplemental Nutrition Assistance Program boosted GDP by a 1.61 multiplier effect in the same period; and increased defense spending had a 1.24 multiplier effect.
Some fiscal policies are more efficient than others. The multiplier effect is an attempt to measure that efficiency.
A government spending program can be less effective because businesses can't or won't ramp up production and hiring as much as expected, or because increased demand drives up inflation.
In any case, a debate over government spending is never purely about the multiplier effect, but about politics and society, as well.
It is quite possible, for instance, that a tax cut for the richest 10% would have the same multiplier effect as a tax credit for middle-class and lower-income parents of young children if both proposed policies cost the same. Both mean additional demand for goods and services and increased business investment to meet that demand.
The debate at this point will be about the appropriate use of government money and the fairness of the tax policy.
The influential economist John Maynard Keynes introduced the concept of the multiplier effect in his 1936 book, "The General Theory of Employment, Interest, and Money."
Keynes asserted that government spending would inevitably have a multiplier effect no matter what it was spent on. The government could build a dam, fill in a swamp, or just toss money out of the windows on Capitol Hill and the effect would be the same: more money in the economy would create even more money in the economy.
That theory has been somewhat countered by other economists who point out that more government spending means higher taxes to pay for it. And higher taxes must cut into the multiplier effect by limiting spending.
When a government enacts fiscal policy, it can result in what's known as a multiplier effect. This occurs when a change in government spending or taxation has ripple effects, such as changes in consumer and business spending. When the multiplier effect is positive and greater than 1, this means that each dollar spent by the government is generating more than just $1 of additional income in the economy.
