The Keynesian Multiplier Fairy Tale

by
Frank Shostak
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Many incorrectly assume that the overall economy’s output increases by a multiple of the increase in expenditure by government, consumers, and businesses. For instance, if out of an additional dollar received individuals spend $0.90 and save $0.10, then if consumers spending were to increase by $100 million, it is held that the overall output in the economy is going to increase by the tenfold of the increase in consumers’ expenditure (i.e. by $1 billion). The following example provides the reasoning behind this way of thinking.

Because of the increase in consumers’ expenditure by $100 million, retailers’ income increases by $100 million. Retailers, in response to the increase in their income, likewise spend 90% of the $100 million (i.e., they raise expenditure on goods 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, ($72.9 million) and so on. The key assumption here is that expenditure by one individual becomes the income of another individual.

At each stage in the spending chain, individuals spend 90% of the additional income they receive. This process eventually ends, allegedly, with the total output higher by $1 billion (10*$100 million) than it was before consumers had increased their expenditure by $100 million. The more is being spent from each dollar, the greater the multiplier is; therefore, the impact of the initial spending on overall output is larger. For instance, if individuals change their habits and spend 95% from each dollar, the multiplier will become 20. If, however, they decide to spend only 80% and save 20%, then the multiplier will be only 5. This also concludes that an increase in savings from each additional dollar weakens the multiplier. Thus, saving weakens the possible effect of an increase in consumer spending on the total output.

Increased Savings Drive the Economy

Do increases in savings really weaken the total output, as the multiplier framework indicates? How can present restrictions of consumption, withholding goods or money from the economy, possibly bring about growth?

First, we ought to understand that the Keynesian model, though we can see “stimulation” take place through demand and consumption, rests on the assumption that consumption and spending are key to greater production and growth. In essence, consumption precedes and generates production. Obviously, this would have been impossible for Robinson Crusoe who had to save and invest in capital goods (e.g., tools) to survive beyond mere physiological existence. Therefore, saving necessarily precedes consumption and capital investment and it is prior saving that enables economic growth.

The owners of goods could decide, instead of just consuming more, to sacrifice in order to produce and/or exchange some of these saved goods for tools and machinery (i.e., capital goods) in order to be able to increase the production of consumer goods. By exchanging a portion of their savings to invest in capital, they are, in fact, transferring their savings to individuals that specialize in making these tools and machinery. Saving sustains and enables these individuals while they invest in the structure of production (e.g., upgrading the infrastructure), which will hopefully be more productive and efficient. This saves greater time, labor, energy, and resources in the future and brings down real prices, thus increasing wealth.

Once the capital structure is further developed, this enables an increase in the production of both producer and consumer goods. Contrary to the popular error, increased saving actually expands the production of goods and does not contract it. Can a mere increase in the demand for consumer goods result in the increase in the overall output by the multiple of the increase in the demand? For instance, to be able to accommodate the increase in his demand for goods, saving and production must occur first. 

Individuals are engaged in production in order to be able to exercise demand for other goods. According to David Ricardo, 

No man produces but with a view to consume or sell, and he never sells but with an intention to purchase some other commodity, which may be immediately useful to him, or which may contribute to future production. By producing, then, he necessarily becomes either the consumer of his own goods, or the purchaser and consumer of the goods of some other person.

What enables the expansion in the supply of consumer goods is the increase and the enhancement in capital goods. Increases in savings, in turn, enables the increase and the enhancement of the production structure. Necessarily, an increase in consumption is limited by the increase in production. From this, we can also infer that a mere increase in consumer demand does not cause the output to increase by the multiple of the increase in this demand. The increase in output is a result of savings that permits, and is not constrained by, the consumers’ demand as such.

Government Spending/Investment

Let us examine the effect of an increase in the government’s demand on an economy’s output. This government and its enforcers who are artificially increasing demand for goods by means of a force, affecting the price and production structures. Could the increase in the enforcers demand result in the increase in output by the multiple of the enforcers increase in demand? On the contrary, it will impoverish everyone. They will be forced to exchange their goods for nothing, against their demonstrated preferences. 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.

Conclusion

John Maynard Keynes’s ideas remain the intellectual apologetic and playbook of economic policymakers at the Fed and government institutions. These ideas permeate the thinking and writing of some of the most influential economists on Wall Street and in academia. The heart of Keynesian philosophy is that what drives the economy is demand for goods and consumption, which could be “stimulated” if necessary. Economic recessions, we are told, are the result of underconsumption and insufficient demand. In the Keynesian framework, an increase in demand and consumption not only lifts overall output, but that output increases by a multiple of the initial increase in the demand.