A:

The Keynesian multiplier was introduced by Richard Kahn in the 1930s. It showed that any government spending brought about cycles of spending that increased employment and prosperity regardless of the form of the spending. For example, a $100 million government project, whether to build a dam or dig and refill a giant hole, might pay $50 million in pure labor costs. The workers then take that $50 million and, minus the average saving rate, spend it at various businesses. These businesses now have more money to hire more people to make more products, leading to another round of spending. This idea was at the core of the New Deal and the growth of the welfare state.

Taken further, if people didn't save anything, the economy would be an unstoppable engine running at full employment. Keynesians wanted to counteract saving by taxing savings to force people to spend more. The Keynesian model arbitrarily separated private savings and investment into two separate functions, showing the savings as a drain on the economy and thus making private investment look inferior to deficit spending. Unless someone holds his or her savings entirely in cash – and true hoarding like this is rare - it's invested either by the individual or by the bank holding the capital. Friedman, among others, showed that the Keynesian multiplier was both incorrectly formulated and fundamentally flawed. (For more, read Free Market Maven: Milton Friedman.)

One flaw is ignoring how governments finance spending: taxation or debt issues. Raising taxes takes the same or more out of the economy as saving; raising funds by bonds causes the government to go in debt. The growth of debt becomes a powerful incentive for the government to raise taxes or inflate the currency to pay it off, thus lowering the purchasing power of each dollar that the workers are earning. Perhaps the biggest flaw is ignoring the fact that saving and investing have a multiplier effect at least equal to that of deficit spending, without the debt downside. In the end, it comes down to whether you trust private individuals to spend their own money wisely or whether you think government officials will do a better job.

For more, see Can Keynesian Economics Reduce Boom-Bust Cycles?

This question was answered by Andrew Beattie.

RELATED FAQS
  1. How does disposable income influence the marginal propensity to consume (MPC)?

    The marginal propensity to consume (MPC) cannot be calculated without disposable income. In the classic Keynesian framework, ... Read Full Answer >>
  2. Is Japan an emerging market economy?

    Japan is not an emerging market economy. Emerging market economies are characterized by low per capita incomes, poor infrastructure ... Read Full Answer >>
  3. Where are the Social Security administration headquarters?

    The U.S. Social Security Administration, or SSA, is headquartered in Woodlawn, Maryland, a suburb just outside of Baltimore. ... Read Full Answer >>
  4. What is the Social Security administration responsible for?

    The main responsibility of the U.S. Social Security Administration, or SSA, is overseeing the country's Social Security program. ... Read Full Answer >>
  5. Is the Social Security administration a government corporation?

    The U.S. Social Security Administration (SSA) is a government agency, not a government corporation. President Franklin Roosevelt ... Read Full Answer >>
  6. When has the United States run its largest trade deficits?

    In macroeconomics, balance of trade is one of the leading economic metrics that determines the trading relationship of a ... Read Full Answer >>
Related Articles
  1. Active Trading Fundamentals

    The Top 5 Impact Investing Firms

    Learn what impact investing is and obtain information on some of the top impact investing firms ranked by total assets under management.
  2. Economics

    Leading Economic Indicators: U.S. Bureau of Labor Monthly Stats

    The Bureau of Labor Statistics' monthly employment figures are a key economic indicator. Here's how they work.
  3. Credit & Loans

    Getting Government Loans For Your Small Business

    Would a government loan provide a more cost-effective way to finance your business? See whether your company qualifies for a government loan.
  4. Investing Basics

    Explaining Trade Liberalization

    Trade liberalization is the process of removing or reducing obstacles that impede the exchange of goods and services between nations.
  5. Investing

    What’s Holding Back the U.S. Consumer

    Even as job growth has surged and gasoline prices have plunged, U.S. consumers are proving slow to respond and repair their overextended balance sheets.
  6. Economics

    The Problem With Today’s Headline Economic Data

    Headwinds have kept the U.S. growth more moderate than in the past–including leverage levels and an aging population—and the latest GDP revisions prove it.
  7. Economics

    Explaining the Participation Rate

    The participation rate is the percentage of civilians who are either employed or unemployed and looking for a job.
  8. Economics

    What Qualifies as Full Employment?

    Full employment is an economic term describing a situation where all available labor resources are being utilized to their highest extent.
  9. Fundamental Analysis

    Is India the Next Emerging Markets Superstar?

    With a shift towards manufacturing and services, India could be the next emerging market superstar. Here, we provide a detailed breakdown of its GDP.
  10. Economics

    A Look at Greece’s Messy Fiscal Policy

    Investigate the muddy fiscal policy, tax problems, and inability to institute austerity that created the Greek crises in 2010 and 2015.
RELATED TERMS
  1. Purchasing Power

    The value of a currency expressed in terms of the amount of goods ...
  2. Monetary Policy

    The actions of a central bank, currency board or other regulatory ...
  3. Cost, Insurance and Freight - CIF

    A trade term requiring the seller to arrange for the carriage ...
  4. International Monetary Fund - IMF

    An international organization created for the purpose of standardizing ...
  5. Inflation

    The rate at which the general level of prices for goods and services ...
  6. Section 1231 Property

    A tax term relating to depreciable business property that has ...

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!