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Is the Keynesian Output Multiplier a Real Thing?

Economics / Economic Theory May 14, 2015 - 10:57 AM GMT

By: Frank_Shostak

Economics

It is accepted by most economists that initial increases in consumer spending or other outlays tend to set in motion a reinforcing process which supposedly strengthens the economic growth by a multiple of initial spending.


The Multiplier Explained

An example will illustrate how initial spending raises the overall output by the multiple of this spending. Let us assume that out of an additional dollar received, individuals spend 90 cents and save 10 cents. Also, let us assume that consumers have increased their expenditures 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 percent of the $100 million. That is, they raise expenditures on goods and services by $90 million. The recipients of the $90 million in turn spend 90 percent of the $90 million, i.e., $81 million. Then the recipients of the $81 million spend 90 percent of this sum, which is $72.9 million and so on. Note that the key in this way of thinking is that the expenditure by one person becomes the income of another person. At each stage in the spending chain, people spend 90 percent of the additional income they receive. This process eventually ends, so it is held, with total output higher by $1 billion (10x$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 is and therefore the impact of the initial spending on overall output is larger. For instance, if people change their habits and spend 95 percent from each dollar the multiplier will become 20. Conversely, if they decide to spend only 80 percent and save 20 percent then the multiplier will be 5.

The Key Role of Savings

Underlying all of this is the assumption that the less that is saved, the larger is the impact of an increase in overall demand on overall output. But is more saving bad for the economy as the Keynesian multiplier model implies?

As we shall see, it is an increase in saving and production, and not an increase in consumption that leads to more economic activity.

Take, for instance, Bob the farmer who has produced twenty tomatoes and consumes five tomatoes. What is left at his disposal is fifteen saved tomatoes (real savings). With the help of the saved fifteen tomatoes Bob can now secure various other goods.

For example, he secures one loaf of bread from John the baker by paying for the loaf of bread with five tomatoes. Bob also buys a pair of shoes from Paul the shoemaker by paying for the shoes with ten tomatoes. Note that real savings at his disposal limits the amount of consumer goods that Bob can secure for himself.

When Bob the farmer exercises his demand for one loaf of bread and one pair of shoes he is transferring five tomatoes to John the baker and ten tomatoes to Paul the shoemaker. Bob's saved tomatoes maintains and enhances the life and well being of the baker and the shoemaker. Likewise, the saved loaf of bread and the saved pair of shoes maintain the life and well being of Bob the farmer. Note that it is saved final consumer goods which sustain the baker, the farmer, and the shoemaker, that makes it possible to keep the flow of production going.

Turning Savings into Production

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 exchanging a portion of their saved consumer goods for 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 whilst they are busy making these tools and machinery.

Once these tools and machinery are built, this permits an increase in the production of consumer goods. As the flow of production expands, this permits more savings all other things being equal. This in turn permits a further increase in the production of tools and machinery. This makes it possible to lift further the production of consumer goods (i.e., raise the purchasing power in the economy). So, contrary to popular thinking, more savings actually expands and not contracts the production flow of consumer goods.

Can the increase in the demand for consumer goods lead to an increase in the overall output by the multiple of the increase in demand? To be able to accommodate the increase in his demand for goods, the baker must have means of payment (i.e., bread to pay for goods and services that he desires). We have seen that the baker secures five tomatoes by paying for them with a loaf of bread. Likewise the shoemaker supports his demand for ten tomatoes with a pair of shoes. The tomato farmer supports his demand for bread and shoes with his saved fifteen tomatoes.

More Production Leads to More Consumption

Whenever the supply of final goods increases, this permits an increase in demand for goods. The baker’s increase in the production of bread permits him to increase demand for other goods. In this sense, the increase in the production of goods gives rise to demand for goods. People are engaged in production in order to be able to exercise demand for goods to maintain their life and well being. 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 the multiple of the increase in consumption. The increase in production is in accordance with what the pool of real savings permits and is not constrained by consumers’ demand as such. Production cannot expand without support from the pool of real savings.

Government and the Multiplier

Let us examine the effect of an increase in the government's demand on an economy's overall output. In an economy which is comprised of a baker, a shoemaker, and a tomato grower, another individual enters the scene. This individual is an enforcer who is exercising his demand for goods by means of force.

Can such demand give rise to more output as the popular thinking has it? On the contrary, it will impoverish the producers. The baker, the shoemaker, and the farmer will be forced to part with their product in an exchange for nothing 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 in Human Action, "… 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."

Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. He is chief economist of M.F. Global. Send him mail. See Frank Shostak's article archives. Comment on the blog.

http://mises.org

© 2015 Copyright Frank Shostak - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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