Understanding the Size of the Government Spending Multiplier: It's in the Sign

Abstract

The literature on the government spending multiplier has implicitly assumed that an increase in government spending has the same (mirror-image) effect as a decrease in government spending. We show that relaxing this assumption is important to understand the effects of fiscal policy. Regardless of whether we identify government spending shocks from (i) a narrative approach, or (ii) a timing restriction, we find that the contractionary multiplier – the multiplier associated with a negative shock to government spending – is above 1 and even larger in times of economic slack. In contrast, the expansionary multiplier – the multiplier associated with a positive shock – is substantially below 1 regardless of the state of the cycle. These results help understand seemingly conflicting results in the literature.

JEL Classification: E62, C32