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Will the Multiplier Effect Boost Income This Time?

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Monetary policy

Historical evidence suggests, an increase in the budget deficit tends to boost overall activity by the same amount (in dollar terms). This implies a fiscal multiplier close to 1. But the multiplier varies over the economic cycle—higher during recessions or when short-term rates are near zero, and lower when an economy runs near fully capacity.

Yet this is not your usual environment. Monetary policy is constrained and with global excess capacity, public investment is less likely to crowd out private investment. We believe fiscal policy should be more effective, and thus the multiplier higher than the historical average.

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Market Realist – Fiscal policy is likely to be more effective this time

The fiscal multiplier suggests that an increase in the government budget deficit causes a proportional increase in consumption (IYC) (IYK) and hence, national income. However, consumption remained unaffected if the fiscal policy changes without any change in the deficit. The consumption rises in proportion to fiscal spending only if there is an increase in the deficit.

Multiplier effect

The argument behind this theory is that incremental spending can lead to increased consumption, boosting national income and then higher consumption. The cycle repeats itself, resulting in an overall increase in the national income in proportion to the incremental amount of spending. The incremental effect on national income is called the multiplier effect.

As a multiplier varies with the economic cycle, the International Monetary Fund expects a fiscal multiplier of 0.5 as a rule of thumb. This means the fiscal tightening by 1% will result in a fall in the GDP growth rate by 0.5%.

Fiscal policy to the rescue

Excess production capacity in many sectors is a global concern that has affected the broader economic growth. China (FXI) (MCHI) has identified as many as 19 industrial sectors like steel, aluminum, and tires with excess capacity.

Such a huge surplus distorts global trade and with monetary policy reaching its limits, judicious use of the fiscal policy that increases productivity seems to be the only option to boost economic growth (IVV).

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