Why is it important to try to determine the size of the fiscal policy multiplier?

Figuring out the multiplier effect in the context of fiscal policy is vital because the size of the multiplier allows policymakers to know how much stimulative effect each dollar can be expected to have in the real economy. The ability to measure and predict the multiplier effect lets policy-makers appropriate funds more efficiently, and allows them to learn from efforts that have had less of an effect than they had hoped.

To illustrate how this multiplier effect works, consider the following. If congress proposes a jobs bill aimed at creating jobs in the renewable energy sector, then they might decide to appropriate ten billion dollars for that aim. Let's say that those ten billion dollars can either go toward building five solar power plants in the southwest or toward building five wind farms in the Midwest.

Those two possible plans might have drastically different impacts based on the number of jobs each creates, even though they will both require the same outlay. If the solar power plants will employ 10,000 workers for twenty years, but the wind power plants will only require 4,000 workers for three years, it is likely that the multiplier effect of the solar plants will be far higher. That is because the workers at the solar plant will continue to earn a living for a longer period of time, and continue to spend the money they make to buy goods and services in the surroundings areas. Those hypothetical 10,000 workers in the southwest will end up buying more groceries, going out to more restaurants, buying more houses or renting more apartments, and so on. That in turn will create and/or sustain more jobs, which will in turn spur more spending and consumption, in a virtuous cycle that spreads through the economy.

Understanding this ripple effect also makes the location of a proposed factory important to consider. The more remote a factory is, for instance, the less likely its workers will be to spend their disposable income on dining, entertainment and other products and services in the nearby community, like movie theaters, restaurants and clothing stores. As a result, the multiplier effect of that fiscal stimulus might be limited. On the other hand, if the arrival of a factory in a small town convinces small businesses to open up nearby in order to serve those workers, that could prove more stimulative than if the power plant is built near an-already bustling city. We know this because new businesses tend to hire more workers than established businesses.

So, before policymakers decide where and how to inject fiscal stimulus, they need to figure out what kind of stimulus will be the most productive. Most people believe that the bailout of the auto industry, as part of the 2009 stimulus package, was a very smart use of funds, because the automobile manufacturing industry supports millions of jobs in both auto manufacturing and in related industries like auto repair, auto part manufacturing, car dealerships, car insurance companies, car washes, gas stations, tire makers, etc.

Economists also believe that giving tax cuts to lower wage workers is more stimulative to the economy in the short term than giving tax breaks to more affluent workers, simply because lower wage workers tend to spend almost all of their wages quite quickly, while higher wage workers tend to save more. All of these factors and more determine the multiplier effect of any fiscal stimulus, and policymakers must consider these carefully before enacting stimulus policies.