How Big (Small?) are Fiscal Multipliers?
Ethan Ilzetzki, Enrique G. Mendoza, Carlos A. Végh
We contribute to the intense debate on the real effects of fiscal stimuli by showing that the impact of government expenditure shocks depends crucially on key country characteristics, such as the level of development, exchange rate regime, openness to trade, and public indebtedness. Based on a novel quarterly dataset of government expenditure in 44 countries, we find that (i) the output effect of an increase in government consumption is larger in industrial than in developing countries, (ii) the fiscal multiplier is relatively large in economies operating under predetermined exchange rate but zero in economies operating under flexible exchange rates; (iii) fiscal multipliers in open economies are lower than in closed economies and (iv) fiscal multipliers in high-debt countries are also zero.
In other words, maintaining an open economy with flexible exchange rates prevents a country from using fiscal policy to stimulate during downturns. Note that under their definition (total trade = 60% of GDP), the U.S. is far from being an open economy. As such, the authors find that the post-1980 multiplier in the U.S. is 0.3 - 0.4. Additionally, when debt-to-GDP is greater than 50%, fiscal multipliers are nil or negative.
It appears that, once again, governments face a tradeoff between maintaining an open economy and being able to effectively moderate downturns using countercyclical policy tools. More specifically, the effect of monetary vs. fiscal stimulus appears to be moderated by exchange rate policy. Under fixed exchange rates, either capital mobility or monetary independence must be sacrificed. Under floating exchange rates monetary independence may be kept, but there's less room to maneuver on the fiscal side. That can leave a country in trouble if it runs up against the zero lower bound.
We may have to further complicate the Unholy Trilemma. In any case, this is a reminder that policy choices can have far-reaching effects.