Boat sailing turbulent economy ocean

Fiscal Multipliers Unveiled: How Government Spending Really Impacts Developing Economies

Lena Voss in Business & Economy June 2025 • 4 min read.

"Unlock the secrets of government spending and its true impact on GDP growth in developing nations. Explore the role of monetary policy, exchange rates, and economic cycles to reveal what really drives fiscal stimulus success."

Governments often use fiscal multipliers to evaluate the potential impact of new fiscal programs, especially in developing economies. Recent studies indicate that these multipliers, which estimate the effect of government spending on economic output, are surprisingly small in these regions. This challenges conventional wisdom and raises questions about the effectiveness of fiscal stimulus in these specific contexts.

A new study dives deeper into understanding the factors influencing the size of fiscal multipliers, with a particular focus on the implied monetary policy reactions. The research explores how exchange rate regimes, business cycle phases, and monetary policy stances affect the ability of government spending to stimulate economic growth. By examining these variables, the study aims to provide a more nuanced understanding of fiscal policy's role in emerging economies.

The research utilizes a panel of quarterly data from 23 developing economies, employing vector auto regression (VAR) within panel data estimation. Additionally, the study examines a panel of 21 developed economies to initially correlate fiscal multipliers with monetary policy reactions. These data-driven investigations aim to uncover the underlying mechanisms that amplify or diminish the impact of fiscal policies in different economic settings.

What Factors Determine the Size of Fiscal Multipliers in Developing Economies?

The size of fiscal multipliers varies significantly depending on the macroeconomic features of the economies under study. Studies have found heterogeneous results for fiscal multipliers even within developed economies, highlighting the importance of specific economic conditions and policy responses. Factors such as exchange rate regimes, business cycle phases, and the level of public debt all play a crucial role.

One key aspect explored in the research is the role of monetary policy. The study performs counterfactual simulations to isolate the impact of government consumption shocks without the influence of monetary policy reactions. This allows for a clearer understanding of how monetary policy decisions can either amplify or counteract the effects of fiscal stimulus.

Exchange Rate Regimes: Fiscal multipliers tend to be lower in developing economies with flexible exchange rate regimes compared to those with fixed exchange rates.
Business Cycle Phases: The effectiveness of fiscal stimulus can vary depending on whether the economy is in a boom or recession phase.
Monetary Policy Stances: The stance of monetary policy, whether expansionary or contractionary, can significantly influence the size of fiscal multipliers.

The study's findings reveal that fiscal multipliers in developing economies with flexible exchange rates are particularly sensitive to economic conditions. Multipliers tend to be higher during economic booms and monetary expansions, suggesting that coordinated fiscal and monetary policies can maximize the impact of government spending. However, during economic slowdowns, fiscal stimulus may have a more limited effect.

Implications for Policymakers

The research underscores the importance of considering the specific economic context when implementing fiscal policies in developing economies. Policymakers should be aware of the potentially low multipliers in flexible-regime economies and strategically time fiscal programs to coincide with economic booms or monetary expansions. Coordinating fiscal and monetary policies can enhance the effectiveness of government spending and promote sustainable economic growth. Further exploration of the financial stability channel and consideration of factors like sovereign default risk and political risk are crucial for optimizing fiscal policy outcomes.

About this Article -

This article was crafted using a human-AI hybrid and collaborative approach. AI assisted our team with initial drafting, research insights, identifying key questions, and image generation. Our human editors guided topic selection, defined the angle, structured the content, ensured factual accuracy and relevance, refined the tone, and conducted thorough editing to deliver helpful, high-quality information.See our About page for more information.

This article is based on research published under:

DOI-LINK: 10.1111/coep.12415, Alternate LINK

Title: The Size Of Fiscal Multipliers And The Stance Of Monetary Policy In Developing Economies

Subject: Public Administration

Journal: Contemporary Economic Policy

Publisher: Wiley

Authors: Jair N. Ojeda-Joya, Oscar E. Guzman

Published: 2018-11-29

Everything You Need To Know

What are fiscal multipliers, and why are they important for understanding government spending in developing economies?

Fiscal multipliers are estimates of how much a change in government spending affects a country's Gross Domestic Product (GDP). They are crucial because they help policymakers in developing economies understand the potential impact of fiscal stimulus programs, such as infrastructure projects or social welfare initiatives. Knowing the size of the fiscal multiplier allows governments to anticipate the effects of their spending decisions on economic output, informing decisions about the scale and timing of fiscal interventions. Recent studies show that fiscal multipliers in developing economies can be surprisingly small, which means that the impact of government spending on GDP might be less than initially anticipated.

How do exchange rate regimes influence the effectiveness of fiscal multipliers in developing economies?

Exchange rate regimes significantly affect the size of fiscal multipliers. The research indicates that fiscal multipliers tend to be lower in developing economies with flexible exchange rate regimes compared to those with fixed exchange rates. In a flexible exchange rate system, the value of the currency can fluctuate freely in response to market forces. This can lead to currency depreciation following fiscal stimulus, potentially offsetting some of the positive effects on GDP. The depreciation makes imports more expensive and can increase inflation, thereby reducing the impact of government spending. Conversely, in a fixed exchange rate system, the exchange rate is managed, which can provide greater stability and allow fiscal stimulus to have a more significant impact on economic growth.

What is the role of monetary policy in determining the size of fiscal multipliers, and how can it be optimized?

Monetary policy plays a critical role in influencing fiscal multipliers. The stance of monetary policy, whether expansionary or contractionary, can significantly impact the effectiveness of government spending. The study emphasizes this, suggesting that coordinated fiscal and monetary policies can maximize the impact of government spending. For instance, during economic booms or monetary expansions, fiscal multipliers tend to be higher. This suggests that if the central bank complements fiscal stimulus with an expansionary monetary policy (e.g., lowering interest rates), the positive effects on GDP are amplified. Conversely, if monetary policy is contractionary, it can counteract the effects of fiscal stimulus, leading to smaller multipliers. Policymakers can optimize monetary policy by carefully considering the state of the economy and coordinating their actions with fiscal authorities to achieve sustainable economic growth.

In what ways do business cycle phases affect the impact of fiscal stimulus in developing nations?

The effectiveness of fiscal stimulus varies depending on the business cycle phase. During economic booms, fiscal multipliers tend to be higher, as the economy has spare capacity to absorb the increased government spending. However, during economic slowdowns, fiscal stimulus may have a more limited effect. In a recession, increased government spending might be less effective because of decreased consumer and business confidence and the risk of crowding out private investment. The impact of fiscal policy is highly contingent on the economic conditions. Policymakers should consider the current business cycle phase when implementing fiscal policies to ensure that interventions are timed to maximize impact and promote sustainable economic growth.

What are the key takeaways for policymakers when implementing fiscal policies in developing economies, according to the research?

The research underscores the importance of considering the specific economic context when implementing fiscal policies in developing economies. Policymakers should be aware of the potentially low multipliers in flexible-regime economies and strategically time fiscal programs to coincide with economic booms or monetary expansions. Coordinating fiscal and monetary policies can enhance the effectiveness of government spending. Furthermore, the research suggests that further exploration of the financial stability channel and consideration of factors like sovereign default risk and political risk are crucial for optimizing fiscal policy outcomes. By understanding these nuances, policymakers can better design and implement fiscal stimulus programs to promote sustainable economic growth in their countries.