The Impact of Fiscal Packages

The financial crisis has produced a very large demand shock so it is not surprising that one overriding driver behind the stimulus packages has been the urgency to adopt measures that have the most significant and possibly rapid impact on demand. Hence, the effectiveness of the fiscal measures could be gauged by assessing their impact on aggregate demand. However, governments may also see the fiscal stimulus as a way to obtain a double dividend, boosting both short-term demand and long-term potential output. This latter aspect may compensate for the time delay that usually separates the decision to spend in public investment from its implementation. The impact on long term growth will be addressed later in this paper.

Consider first the impact on demand. The impact of fiscal packages on demand depends directly on the size of fiscal multipliers, the credibility of the sustainability of fiscal stimulus and the uncertainty of the current and future economic environment, and the intensity and effectiveness of international cooperation. Furthermore, tax and spending measures have different impacts. Even in normal times, tax cuts could have a limited impact on household consumption if “Ricardian” consumers expect higher taxes in the future. Apart from this, in times of crisis the effectiveness of tax relief in supporting demand may vary significantly with both the degree of uncertainty faced by households and the amount of outstanding household debt, with higher levels in either case increasing the household's propensity to save. The financial crisis is likely to reinforce both effects, but as the recession fades, the positive impact of tax cuts on consumption could increase as uncertainty decreases and private sector wealth slowly returns to normal. However, even when uncertainty is reduced, households may need to increase savings in order to face the increased debt obligations that result from shocks to financial markets and, consequently, net wealth accumulation may take longer than under normal circumstances.

The measurement of the impact on demand depends on multipliers. Estimates of fiscal multipliers vary greatly across countries and budget items (both revenue and spending). Table 3 [ PDF 35.2KB | 1 page ] presents ranges of estimates of fiscal multipliers based on a number of empirical studies surveyed in OECD (2009). Other things being equal, spending multipliers are larger than tax multipliers. Purchases of goods and services (which include infrastructure investment) multipliers exhibit the highest values, also with respect to transfers to households. Finally, multipliers are larger in the second year after the impact, both for tax relief measures and purchases of goods and services.

As previously mentioned, irrespective of the composition effect, the size of fiscal multipliers becomes more difficult to predict in times of deep economic crisis, when uncertainty about the future prevails and both households and firms adopt more precautionary attitudes. From this perspective, multipliers used to assess the impact of stimulus packages may be smaller than under normal circumstances. On the other hand, they may be larger than in normal times if the fiscal boost is likely to ease the credit constraint that both households and businesses face in the crisis.

Also, as mentioned above, fiscal multipliers vary inversely with the degree of openness, accounting for the more limited propensity of relatively open economies to increase their fiscal stimulus. This would call for a stronger effort at international cooperation, a point I will return to later. Finally, the size of fiscal multipliers also depends on the degree of monetary tightness. A tighter monetary stance will lead to a smaller ex post multiplier.

The elements just outlined account, at least in part, for the high degree of uncertainty that surrounds growth forecasts that incorporate the fiscal stimulus. Hence, the full impact of fiscal stimuli is yet to be fully understood. It also remains unclear if and to what extent new stimulus will be needed. As mentioned above, the expected size of the output gap suggests that the stimulus will have to be maintained for some time, possibly well into 2010.

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