Size and Impact of Fiscal Multipliers - An Analysis of Selected South Asian Countries

• Author: MUHAMMAD AZMAT HAYAT AND HAFSAH QADEER

Abstract. Due to recent global financial and economic crisis a key issue in current research and for policy makers is the size of fiscal multipliers. Proper knowledge of fiscal multipliers is essential for the designing and implementation of fiscal policies. This research work intends to contribute in the literature on the size of fiscal multipliers for selected South Asian countries (Bangladesh, India, Pakistan and Sri Lanka) by using Panel Vector Autoregressive (PVAR) technique over the period 1982-2014. Results obtained from accumulated Impulse Response Functions (IRFs) show that government expenditures have overall positive impact on output in these countries. Among expenditures government investment multipliers are andgt;government consumption multipliers on all time horizons. This finding suggests that governments should put more emphasis on public investment while allocating budget in these countries. When controlling for public debt, cumulative fiscal multipliers exhibit lower values.

Additionally, the results also show that during business cycle phases government expenditures show more efficacies in recessions while lower effect in expansions.

Keywords: Fiscal multipliers, Panel vector autoregressive, Impulse response function, Government expenditures, Business cycles

1. INTRODUCTION

   Many economists are of the view that macroeconomic stabilizations should be handled mainly by monetary policy (Farhi and Werning, 2012). But unfortunately monetary policy is not free from constraints that restrict its efficiency. For example, the economy may entrap into the situation of liquidity trap (close to lower bound interest rate scenario) that prohibit further reduction in interest rates. Furthermore, there are many countries that belong to currency unions (like European countries, Eastern Caribbean Currency Union (ECCU) etc.) or states with in the country don’t have the choice of independent monetary policy (Farhi and Werning, 2012).

   The latest worldwide economic crisis had brought the attention of authorities towards the usefulness of fiscal policy for two reasons: the first argument was that during that time, the credit and monetary policy had hit its lower limit (a situation of zero lower bound interest rate),1 in this situation there is no choice for policy makers to rely on the fiscal policy for stimulating economic activity and employment during the period of slump. The second argument was that it was expected to have long lasting recessionary phases across the countries. In this situation, fiscal stimulus regardless of its conventional lags in implementation would have adequate time to give positive results and stable the economy.

   The most important channel through which global financial crisis (GFC) hit the economies of South Asia was exports. The United States and European economies were major markets for the exports of South Asian countries. There was a sharp decline in the growth of exports of the South Asian countries due to a sharp decline in demand in the Western economies.

   TABLE 1 Growth of Exports Demand, Annual Change, Percentage

   Countries 2006 2007 2008 2009 2010 2011 2012 2013 2014

   Bangladesh 25.5 13.0 7.1 0.0 0.9 29.3 12.5 2.5 3.2

   India 20.4 5.9 14.6 -4.7 19.6 15.6 6.7 7.3 -0.8

   Pakistan 9.9 1.5 -4.6 -3.4 15.7 2.4 -15.0 13.6 -1.6

   Sri Lanka 3.8 7.3 0.4 -12.3 8.8 11.0 0.2 5.9 4.9

   The recent crisis was due to the shortage of demand. During zero interest rate situations the basic goal of a policy should not be to increase aggregate supply by providing aggregate supply incentives. Instead the goal of a policy should be to boost up the overall spending of an economy, i.e. aggregate demand. Output is demand determined at zero interest rate situations. Correspondingly, aggregate supply is usually relevant in the model because it talks about future inflation from the expectations of people. Therefore, we can say that the policies that are formulated to boost up the aggregate supply are counter-productive because at zero interest rate they can create deflationary pressure in an economy. So, as a consequence of this policy makers should not formulate such policies that increase the supply of goods when the problem is that there are not much buyers (Eggertsson, 2011).

   Fiscal policy has an advantage over monetary policy, that increase in government spending can immediately increase the aggregate demand.

   From 2008-2009, both the developed and developing nations has undertaken various fiscal policy stimuli to boost the declining economy. It is not possible to access the impact of the fiscal policy on economic growth without proper study on the size, sign and the magnitude of the fiscal multipliers. Moreover, size of expenditure (spending) multipliers also portrays the quality and effectiveness of fiscal policy. These factors and also the lack of empirical estimations on the size of fiscal multipliers for a panel of South Asian economies (Pakistan, India, Bangladesh and Sri Lanka) have been a source of motivation behind this study. This research tries to investigate the size and sign of government expenditures and government revenue (taxes) multipliers for selected South Asian countries. This study also tries to estimate the effect of debt dynamics and business cycle phases (recession and expansion) on the magnitude of fiscal multipliers.

   This research paper is structured as follow: Section II discusses the theoretical mechanism behind fiscal multipliers; Section III reviews the background literature; Section IV discusses the data and methodology; Section V discusses the estimation and results and in section VI conclusion and policy implications are discussed.

2. THEORETICAL MECHANISM BEHIND FISCAL MULTIPLIERS

   Initially the concept of “multiplier” was introduced by Kahn (1931) and then further elaborated by Keynes (1936). According to Keynes-Kahn textbook version of multipliers if public expenditure (G) increases by one unit, as a consequence of this aggregate demand increases by more than one unit. The initial round of spendings stimulate the next rounds of spending in this way the final impact on output is multiplier times the original increase in spending. If the initial increase in public spending is ΔG and marginal propensity to consume (MPC) is “c” then change in output is k times ΔG, where k is the fiscal multiplier and equals k = 1 / (1 – c) and for taxes it is given by –MPC / (1 – MPC), under the assumption of close economy. The value of multiplier is the accumulated effect on output through various rounds of spending2 (Bose and Bhanumurthy, 2015).

   In simple terms fiscal multiplier refers to the ratio of change in output due to some exogenous change in fiscal instrument – such as government expenditures or government taxes. There are several types of fiscal multipliers depending on different time horizons. Impact multiplier is the ratio of change in output (at time t0) due to an exogenous change in the fiscal variable at time t0, i.e. ΔYt0 / ΔGt0. Cumulative multiplier is defined as the ratio of cumulative change in output due to cumulative exogenous changes in the fiscal variables. ΔYt0 + i / ΔGt0 + N where i = 0, 1, …, N.

   In the case of zero lower bound (ZLB) interest rate situation the multiplier for output is andgt;unity. The whole mechanism behind this result is that government spending promotes inflation in an economy. As the nominal interest rate is fixed, this reduces the real interest rate which motivates the investors to enhance their investment (their current spending). The increase in consumption in turn of this leads to more inflation, in this way it creates a feedback loop. The fiscal multiplier is increasing in the degree of price flexibility. The whole mechanism relies on the response of inflation (Farhi and Werning, 2012). The core thinking behind taking these policy actions are that both recession and inflation are opposite of one another. During periods of inflation there is too much money circulating in an economy, but during the phases of recession there is not enough money.

   So during recessionary phases in order to put money in the economy government increases its expenditures to create inflationary situation in the economy.

   Many macroeconomics models predict that a rise in government spending will have an expansionary effect on aggregate output; these models are generally differing according to their implicit effect on consumption. As the later variable (consumption) is the largest component of aggregate demand, its response is the crucial determinant about the size and sign of government spending multiplier.

   The weak Keynesian and IS-LM model predict that consumption will increase after a shock in government spending. In these models MPC is high because consumers are not forward looking and they do not fully consider that in future taxes will increase to compensate for current increase in debt and increase in government spending due to their finite horizon. In other words, in the IS-LM model consumers behave in a non-Ricardian fashion, i.e. rule of thumb consumers. From another perspective when a shock in government spending is given its effect on output is weaken due to domestic crowding out effects from investment for a large economy, although in a small but financially integrated economy the size of the fiscal multiplier is further curtailed due to negative effect of real exchange rate on foreign demand and marginal propensity to imports.

   The Real Business Cycle (RBC) models are considered as the stochastic versions of the Classical Models. The characteristics of these models are the presence of micro foundations and intertemporal considerations. The RBC model has infinitely lived and forward looking behaviour consumers with no nominal rigidities and whose consumption decision are based on intertemporal considerations. In these models positive government spending shock will have a negative wealth effect and this positive shock reduces the consumption in...