Government investment—things like infrastructure building—results in higher multipliers. Economists at the IMF have calculated the long-run multiplier at 1.5 for developed countries and 1.6 for developing countries. In other words, developing countries really benefit from government investment over government consumption. Investment can build the productive capacity of the economy, resulting in beneficial long-term effects.

Many governments in developed nations have been introducing fiscal austerity programmes – cutting spending and lifting taxes in a bid to lower their budget deficits. The fiscal multiplier effect is important here too. If the multiplier is 0.5, then an initial government expenditure reduction of 1 per cent of GDP reduces real output by 0.5 per cent.If, however, the multiplier is 1.7, then the same initial public spending cut of 1 per cent of GDP would reduce real output by 1.7 per cent. The big danger of a high fiscal multiplier is that a period of deep cuts in state spending will cause an even larger drop in GDP which in turn will increase the size of the budget deficit. Fiscal austerity can turn out to be self-defeating.

One problem is that the actual value of the multiplier effect is likely to change at different points of the economic cycle.

(Source: Adapted from the Economist and other news reports, July 2013)

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