A multiplier is a factor in economics that proportionally augments or increases other related variables when it is applied. Multipliers are commonly used in the field of macroeconomics—the area of economics that studies the behavior of the economy as a whole. There are a number of different multipliers including the earnings multiplier, fiscal multiplier, investment multiplier, and the Keynesian multiplier.
Read on to find out more about the Keynesian multiplier and how it works.
- A Keynesian multiplier is a theory that states the economy will flourish the more the government spends.
- According to the theory, the net effect is greater than the dollar amount spent by the government.
- Critics of this theory state that it ignores how governments finance spending by taxation or through debt issues.
What Is the Keynesian Multiplier?
Famed British economist John Maynard Keynes formally introduced the concept of the multiplier in his "The General Theory of Employment, Interest, and Money" in 1936.
During the depression of the 1930s Keynes understood that the classical thinking where supply would create its own demand does not always work. He noted that in the Great Depression the main problem was a lack of aggregate demand. He also noted that the government spending could add to aggregate demand and that this fiscal stimulus would create a “multiplier effect” through increases in consumer demand. Regardless of the type of government spending, it will lead to cycles of economic prosperity and increased employment, raising gross domestic product (GDP) by a larger amount of the increase. So $1 billion in government spending will raise a country's GDP by more than the amount spent.
To summarize these concepts, we note that in a simple closed economy that aggregate demand can be represented by the following expression:
- Y=Aggregate demand
- C=Consumer demand
- I=Investment demand
- G=Government demand
Keynes also introduced the concept of the consumption function:
- m= the marginal propensity to consume (MPC) with m<1 and for purposes of this discussion we will assume is estimated at .75 indicating that when consumers receive additional income, they spend 75% and save 25%. Investment demand was primary determined by entrepreneurial spirits, interest rates (monetary policy) and current business conditions while government demand was determined by the fiscal decisions made by government
In this framework we can express aggregate demand as:
Solving this expression for Y results in:
Where the term 1/(1-m) is the Keynesian income “multiplier.” In our example with m=.75 the multiplier is
If Y falls due to a problem with Investment spending (i.e., business confidence) then the government can step in to increase aggregate demand by increasing G. If m=.75 then the multiplier is 4 indicating a 1 dollar increase in G, all other things being equal would result is an increase in income of 4 dollars in Y.
This was the contribution Keynes made to the economic thinking of the time and was fundamental then, and now, in the role of fiscal policy in getting the economy back to full employment.
Keynesian Multiplier at Work
Here's a hypothetical example of how this multiplier works. Let's say a $100 million government project—whether to build a dam or to 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. In short, one dollar of government spending will generate more than a dollar in economic growth. This idea was at the core of the New Deal and the growth of the welfare state.
The core of the New Deal and the growth of the welfare state are based on the theory of the Keynesian multiplier.
Taken further, if people didn't save anything, the economy would be an unstoppable engine running at full employment. Keynesians wanted to tax savings to encourage people to spend more. The Keynesian model—developed by British economist John Maynard Keynes—arbitrarily separated private savings and investment into two separate functions, showing the savings as a drain on the economy and thus making them look inferior to deficit spending. But unless someone holds their savings entirely in cash—and true hoarding like this is rare—savings are investing, either by the individual or by the bank holding the capital.
Criticism of Keynesian Multiplier
Milton Friedman, among others, showed that the Keynesian multiplier was both incorrectly formulated and fundamentally flawed. One flaw is ignoring how governments finance spending by taxation or through debt issues. Raising taxes takes the same or more out of the economy as saving, while 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, however, is ignoring the fact that saving and investing have a multiplier effect at least equal to that of deficit spending. This, of course, comes 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.