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How Magical is the Keynesian Multiplier?

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Tags Money and BankingOther Schools of Thought

05/18/2017

For most economists and financial commentators, the heart of economic growth is the increase in the demand for goods and services. The view is that increases or decreases in demand are behind rises and declines in the economy’s production of goods and services. It is also held that the economy’s total output increases by a multiple of the change in expenditure by government, consumers, or businesses.

An example will illustrate how an increase in spending raises overall output by a multiple of this spending.

Let us assume that out of an additional dollar received, individuals spend $0.90 and save $0.10. Also, let us assume that consumers have increased their expenditure by $100 million. As a result of this, retailers’ revenue rises by $100 million. Retailers in response to the increase in their income consume 90% of the $100 million, i.e., they raise expenditure on goods and services by $90 million. The recipients of these $90 million in turn spend 90% of the $90 million, i.e., $81 million. Then the recipients of the $81 million spend 90% of this sum, which is $72.9 million and so on. Note that the key feature of this way of thinking is that expenditure by one person becomes the income of another person.

At each stage in the spending chain people spend 90% of the additional income they receive. This process eventually ends, so it is held, with total output higher by $1 billion (10*$100 million) than it was before consumers had increased their initial expenditure by $100 million.

Observe that the more that is being spent from additional income the greater the multiplier, and therefore the impact of the initial spending on overall output is larger. For instance, if people change their habits and spend 95% from each dollar the multiplier will become 20. Conversely, if they decide to spend only 80% and save 20% then the multiplier will be 5. All this means that the less that is saved the larger the impact on overall output per increase in overall demand.

Following this logic it is not surprising that most economists today are of the view that by means of fiscal and monetary stimulus it is possible to prevent an economy falling into recession.

In fact the former Federal Reserve Chairman Ben Bernanke has even suggested that there is good evidence that cash that goes to low and moderate income individuals is more likely to be spent in the near term — hence from this perspective it is going to be more beneficial for economic growth.1

The popularizer of the magical power of the multiplier, John Maynard Keynes, wrote,

If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coal mines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course by tendering for leases of the note-bearing territory), there need be no more unemployment and with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is.2

Is the Multiplier Real?

Is more savings bad for the economy, as the multiplier model indicates? 

A producer of final consumer goods produces a level of output of those goods. If that level of output is only sufficient for the personal needs of that producer then there is nothing left over to exchange for other producers’ goods and services. In other words, there can be no demand from this producer for other producers’ output unless output is above the level that is required to support this producer’s subsistence.

This applies equally to all producers throughout an economy — without excess production (i.e., excess supply) there can be no demand and no ability to spend on the output of others.

Now, the owners of final consumer goods, rather than exchanging them for other consumer goods, could decide to use them to secure better tools and machinery. With better tools and machinery a greater output and a better quality of consumer goods can be produced some time in the future.

Note that by transferring a portion of their saved consumer goods to the production of tools and machinery the owners of consumer goods are in fact transferring their real savings to individuals that specialize in making these tools and machinery. Real savings sustain these individuals while they are busy making these tools and machinery.

We Need to Produce Before We Can Spend

Once these tools and machinery are built, this permits an increase in the overall production of consumer goods. As the flow of production expands this permits more savings all other things being equal, which in turn permits a further increase in the production of tools and machinery. This in turn makes it possible to further lift the production of consumer goods, i.e., raise the purchasing power in the economy. So, contrary to popular thinking, more savings actually expands, rather than contracts, the production flow of consumer goods.

Can an increase in the demand for consumer goods lead to an increase in overall output by a multiple of the initial increase in demand? No. The increase in the demand for goods and services is constrained by the increase in real savings.

Note that once the supply of final goods increases this permits an increase in demand for goods, all other things being equal. It is the increase in the production of goods that gives rise to increased demand for goods due to the increased surplus produced over and above subsistence.

We have seen that what enables the expansion in the supply of final consumer goods is the increase in capital goods or tools and machinery. What in turn permits the increase in tools and machinery is real savings. We can thus infer that the increase in consumption must be in line with the increase in production. From this we can also deduce that consumption doesn’t cause production to increase by a multiple of the increase in consumption. The increase in production is in accordance with what real savings permit and is not constrained by consumers’ demand as such. Production cannot expand without the support of real savings, i.e., something cannot emerge out of nothing.

Increasing Demand Without First Increasing Production and Savings 

Let us examine the effect of an increase in the government’s demand on an economy’s overall output.

Can such demand give rise to more output as popular wisdom has it? On the contrary, it will impoverish producers. Producers will be forced to part with their product in an exchange for goods and services that are likely to be on a lower priority list of producers and this in turn will weaken the flow of production of final consumer goods. Again, as one can see, not only does the increase in government outlays not raise overall output by a positive multiple, but on the contrary this leads to the weakening in the process of wealth generation in general. According to Mises,

…there is need to emphasize the truism that a government can spend or invest only what it takes away from its citizens and that its additional spending and investment curtails the citizens’ spending and investment to the full extent of its quantity.3

But perhaps the introduction of money makes the multiplier possible?

The introduction of money does not alter our conclusions. Money only helps to facilitate trade amongst producers — it doesn’t generate any real stuff. 

Paraphrasing Jean Baptiste Say, Mises argued that,

Commodities, says Say, are ultimately paid for not by money, but by other commodities. Money is merely the commonly used medium of exchange; it plays only an intermediary role. What the seller wants ultimately to receive in exchange for the commodities sold is other commodities.4

When an individual increases his spending by $100 all it means is that he has lowered his demand for money by $100. We can also say that the individual has exercised his claim over real saved goods to the tune of $100. The seller of goods has now acquired a $100 claim on real savings. We can also say that the seller’s demand for money has increased by $100. All this, however, doesn’t give rise to an overall increase in output, as suggested by popular thinking. What we have here is that the claims on real savings were shifted from one individual to another individual. The increase in monetary spending does not give rise to any increase in real income in the economy. Likewise, if the seller now spends 90% of $100 all that we will have here is a situation wherein his demand for money has fallen by $90, i.e., he has exercised his claim on the existing pool of real goods to the extent of $90. (Somebody else’s demand for money has now risen by $90.)

Also, with all other things being equal, if individuals have increased their expenditure on some goods then they will be forced to spend less on other goods. This means that the overall spending in an economy remains unchanged.

Only if the amount of money in the economy increases, all other things being equal, will spending in money terms follow suit. However, in this case also the increase is not on account of some multiplier but on account of the increase in the money supply. The increase in monetary expenditure on account of an increase in money supply cannot however produce the expansion in real output as the popular story has it. All that it will generate is a reshuffling of the existent real savings. It will enrich the early receivers of the new money at the expense of later receivers or no receivers at all.

Obviously, then, a loose monetary policy which is aimed at boosting consumers’ demand cannot boost real output by a multiple of the initial increase in consumer demand. Not only will loose money policy not lift production, but on the contrary it will impoverish wealth generators in exactly the same way as the increase in government demand does.

John Maynard Keynes’s writings remain as influential today as they were eighty years ago. His ideas remain the driving force of economic policymakers at the Fed and government institutions. These ideas permeate the thinking and writings of the most influential economists on Wall Street and in academia.

The heart of the Keynesian philosophy is that what drives the economy is demand for goods. Economic recessions are predominantly the result of insufficient demand. In the Keynesian framework an increase in demand not only lifts overall output but that output increases by a multiple of the initial increase in demand. Within this framework something can be created out of nothing.

In the real world, an artificial boost in demand that is not supported by production leads to the depletion of real savings and, contrary to the Keynesian view, to a shrinking in the flow of real wealth, i.e., it results in economic impoverishment.

  • 1. Ben S.Bernanke in his testimony to the House of Representatives Budget Committee responding to questions January 17, 2008.
  • 2. J.M. Keynes, The General Theory of Employment, Interest and Money (London: Macmillan & Co., 1964), p. 129.
  • 3. Ludwig von Mises, Human Action, 3rd rev. ed. (Chicago: Contemporary Books),  p. 744.
  • 4. Ludwig von Mises, "Lord Keynes and Say's Law," in The Critics of Keynesian Economics, edited by Henry Hazlitt (Lanham, Maryland: University Press of America, 1983), p. 316.

Frank Shostak's consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.
Image source: Ervins Strauhmanis Follow www.flickr.com/photos/ervins_strauhmanis/
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