Size of the government spending multiplier in the recent financial crisis

Abstract

SIZE OF THE GOVERNMENT SPENDING MULTIPLIER IN THE RECENT FINANCIAL CRISIS

In this thesis I study the size of the fiscal multiplier in the economic conditions of the recent financial crisis. The objective is to find out how large the fiscal multiplier can be expected to be in the 2008 crisis and what are the main factors affecting its size. The thesis is conducted in the form of a literature review, where I base my analysis on previous studies and relevant theory.

Throughout the thesis I follow a New Keynesian perspective assuming some degree of price and wage stickiness. The assumption is essential for achieving higher multipliers and is widely used in academic literature on fiscal stimulus.

I find that in a financial crisis with zero interest rates, fiscal multipliers can be clearly higher than during normal times. Provided that the stimulus measures meet certain requirements, the multiplier can reach values greater than 1. These requirements state that stimulus needs to be purely temporary and accompanied by accommodative monetary policy, and higher fiscal spending should be followed by spending cuts in the future. Fiscal measures should preferably not be subject to considerable implementation lags and the stimulus period should last precisely as long as the financial distress continues. The announcement of upcoming stimulus measures has to be credible.

The 2008 crisis and the Great Depression share similarities, the most important ones being the magnitude and global nature of the crises. Fiscal policy could have contributed more to the recovery from the Great Depression had it been used more extensively, and the resulting multipliers could have been larger too. Therefore, the multipliers for the current recovery period could be higher than in the 1930s and fiscal policy’s contribution might be more significant in the recent crisis.