The Spending Multiplier in the Medium Run

Abstract

Most of the discussion about fiscal stimulus focuses on the multiplier of government spending on impact. In this paper we shift the focus to the multiplier at the end, i.e., to the period in which a deficit spending program terminates. We show that recent time-series analyses and neoclassical as well new Keynesian business cycle models predict that the multiplier turns negative before spending expires. This means that aggregate output at the time of expiry of fiscal stimulus is lower than it could be without deficit spending. Here, we show why this phenomenon is a general outcome of mainstream business cycle theory and explain the underlying mechanism. Using phase diagram analysis, we prove that the aggregate capital stock at the time of expiry of fiscal stimulus is lower than it would be without a deficit spending program. This fact explains why aggregate output is below its laissez faire level as well.