Written by Dan Lieberman, Alternativeinsight
Can someone clarify a significant economic and well accepted proposition that bothers me?
The notion that the Keynesian multiplier means that "an exogenous increase in spending, such as an increase in government outlays, increases total spending by a multiple of that increase," is troublesome. Is it possible to add one dollar to the money supply and magically turn it into more dollars? I don't think this is possible. I believe economists have misinterpreted the multiplier. To me, if it is not a multiplier, then the multiplying factor can never be more than one.
The concept actually states that if the total investment is not consumed then not all of the investment is available for reproduction, and with time the value of this investment to the economy will fade to nothing.
Let me explain.
First, the proper parameters must be set.
- Velocity of money and time are not factors in the concept;
- Added borrowing, such as fractional banking, is not factors in the concept;
- Spending is only for produced goods and not for any services. (In the service economy the added GDP can be multiplied. A buys a service from B who buys a service from C and so on...)
- The government spending is deficit spending, supported by borrowing and not by taxes.
The aspects of the Keynes's model, which support the multiplier, present these arguments:
- The people who receive this money then spend most on consumption goods and save the rest.
- This extra spending allows businesses to hire more people and pay them, which in turn allows a further increase in consumer spending.
Missing from this argument is that the original production, stimulated by the investment, is only repeated by money already available in the economy. A simple example shows this phenomenon.
Let us start with four supply units and an equal four demand units. Government deficit spending (investment) of one unit purchases trucks and so a trucking company adds an additional production facility for another supply unit.
The company hires workers, makes no profit and pays them the total of one demand unit, which is equal to the produced supply unit. The government has the trucks and there is an additional one demand unit in the economy. The company has no added assets to its books and cannot repeat the production process unless someone else invests a unit for more supply.
Four demand units can purchase the available supply of four supply units ;which allows for re-production and another four units of supply. The government has the other supply unit. So, we are left with one demand unit in the economy. Either one of two occurrences can follow:
- The unused demand unit can be invested in production of another supply unit. We then have five supply units and five demand units.Result - The original government investment has increased the economy's demand and supply by only the equivalent of the original investment. The multiplier is one.
- The unused demand unit is only partially invested but also demands goods.Result - The multiplying factor is less than one and because demand is greater than supply, some raise in prices and mild inflation occur in order to equalize supply and demand...
It is also obvious that if government spending had a multiplier factor of .greater than one, then severe government deficit spending is beneficial. However, deficit spending only replaces the lack of private borrowing and historical statistics of GDP and money supply demonstrate that their growths have always been less than the spending - so where is there a multiplier of greater than one?
Appreciate a reply so I can sleep tonight. Please leave comments.
Thanks for your interest.