Reassessment of the Fiscal Multiplier in Developing Countries: Regime-Switching Model

Abstract

The existing literature on fiscal policy has mainly employed linear models that found a small fiscal multiplier in developing economies. These findings challenge the importance and effectiveness of fiscal policy for these countries. However, linear models are not capable of distinguishing the size of a fiscal multiplier in the different phases of economic cycles. Responding to previous studies that confirm the regime dependency of a fiscal multiplier, we develop a non-linear panel threshold vector autoregression model to measure the size of the fiscal multiplier for developing countries. Our findings confirm asymmetry in the response of GDP to government expenditure shock during periods of recovery and downturn. Our main result shows that the response of GDP to government expenditure shock during a recovery period in developing countries is double that for developed ones. Our results also confirm a significantly larger fiscal multiplier during recovery than in an economic downturn. (JEL codes: E32, E62, G15, and C54)