Macroeconomic Analysis

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Macroeconomic Research Note

The importance of fiscal-monetary interactions as a crucial determinant of the effects of fiscal policy on GDP

 September 23th, 2014.

The impact of government fiscal stimulus depends on key country characteristics, including the level of development, the exchange rate regime, openness to trade, and public indebtedness.


An analysis of a quarterly dataset on government expenditures for 44 countries (20 high-income and 24 developing) from 1960 to 2007, concluded that the output effect of an increase in government consumption is larger in industrial than in developing countries. That response—which is called the fiscal multiplier—is relatively large in economies operating under a predetermined exchange rate, but it is zero in economies operating under flexible exchange rates. The analysis also concluded that the fiscal multipliers are smaller in open economies than in closed economies, and are zero in high-debt countries.


In developing countries, output initially responds negatively to increases in government consumption. Only after a lag of two to four quarters does output rise in response to an increase in government consumption, and the cumulative output response is not statistically different from zero. Furthermore, increases in government consumption are less persistent (dying out after approximately six quarters) in developing countries than in high-income countries.


Exchange rate flexibility is critical: economies operating under predetermined exchange rate regime have long-run multiplier greater than one in some specifications, while economies with flexible exchange rate regimes have multiplier that are essentially zero. The differences in the responses to increases in government consumption in countries with fixed and flexible exchange rate regimes are largely attributable to differences in the degree of monetary accommodation to fiscal shocks in these nations. The results imply that the central banks’ response to fiscal shocks is crucial in assessing the size of fiscal multipliers.


Openness to trade is another critical determinant of the size of the fiscal multiplier. Economies that are relatively closed, whether because of trade barriers or larger internal markets, have long-run multipliers of around 1.3 to 1.4, but relatively open economies have negative multipliers. Indebtedness also matters. When the outstanding debt of the central government exceeds 60 percent of GDP, the fiscal multiplier is not statistically different from zero on impact and it is negative in the long run. Thus, the 60-percent-of-GDP threshold is a critical value above which fiscal stimulus may have a negative, rather than a positive impact on output.


Only in developing countries is the multiplier on government investment significantly higher than the multiplier on government consumption. In those countries, the multiplier on government investment is positive and close to 1 in the medium term. Thus, the composition of expenditure may play an important role in assessing the effect of fiscal stimulus in developing countries.


Given increasing trade integration and the adoption of flexible exchange rate arrangements and inflation targeting regimes, these results suggest that fiscal multipliers are likely to be modest in many nations. Moreover, with a large number of countries now carrying very high public debt ratios, fiscal stimuli are likely to become even weaker, and potentially yield even negative multipliers in the near future. At the same time, this dataset analysis provides new evidence of fiscal policy on GDP.


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