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. What is the role of deficit spending in fiscal policy?

    Read about the role deficit spending can play in a government's fiscal policy, and learn why economists are torn about the ... Read Answer >>
  2. How do I negotiate a lower annual percentage rate (APR) with my credit card company?

    Discover the main factors of economic policy that, according to Keynesian economic theory, drive the marginal propensity ... Read Answer >>
  3. How can a change in fiscal policy have a multiplier effect on the economy?

    Learn about how changes in fiscal policy have a multiplier effect on the economy. The goal of expansionary fiscal policy ... Read Answer >>
  4. Why is Keynesian economics sometimes called demand-side economics?

    Learn why Keynesian economics is sometimes called demand-side economics, and find out how government spending increases aggregate ... Read Answer >>
  5. How does the crowding out effect influence the multiplier effect of a government ...

    Understand the theories of the multiplier effect and the crowding-out effect, and learn how these two theories represent ... Read Answer >>
Related Articles
  1. Insights

    Can Keynesian Economics Reduce Boom-Bust Cycles?

    Learn about a British economist's proposed solution to a common economic problem.
  2. Insights

    A Look at Fiscal and Monetary Policy

    There's a debate over which policy is better for the economy. Find out which side of the fence you're on.
  3. Trading

    Giants Of Finance: John Maynard Keynes

    This rock star of economics advocated government intervention at a time of free-market thinking.
  4. Insights

    Free Market Maven: Milton Friedman

    As proponent of free market capitalism, this economist changed the way the world's economies operate.
  5. Financial Advisor

    High Debt and Savings Rates Hinder China's Economy

    China's recent debt explosion seems odd considering its high savings rate, but the two are related and may provide the key for renewed growth.
  6. Insights

    The U.S. National Spending And Debt

    Just like any average American household, government overspending can carry on for extended periods by rolling over debt and borrowing more and more money in what seems like a never-ending game ...
  7. Insights

    The National Debt Explained

    We know it's growing, but we don't know exactly how. An in-depth look why the U.S. Government's debt continues to balloon and what it all means for you.
  8. Personal Finance

    How Savings Are Saving The Economy

    Even with inflation fears, saving money is still sage advice in a recovering economy.
RELATED TERMS
  1. Keynesian Economics

    Keynesian economics is an economic theory of total spending in ...
  2. Keynesian Put

    A Keynesian Put is the expectation that markets and the economy ...
  3. Government Purchases

    Expenditures made in the private sector by all levels of government, ...
  4. Deficit

    The amount by which a resource falls short of a mark, most often ...
  5. Economic Stimulus

    Attempts by governments or government agencies to financially ...
  6. Savings Rate

    The amount of money, expressed as a percentage or ratio, that ...
Hot Definitions
  1. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
  2. Promissory Note

    A financial instrument that contains a written promise by one party to pay another party a definite sum of money either on ...
  3. SEC Form 13F

    A filing with the Securities and Exchange Commission (SEC), also known as the Information Required of Institutional Investment ...
  4. Fixed Asset

    A long-term tangible piece of property that a firm owns and uses in the production of its income and is not expected to be ...
  5. Absolute Advantage

    The ability of a country, individual, company or region to produce a good or service at a lower cost per unit than the cost ...
  6. Nonce

    Nonce is a number added to a hashed block, that, when rehashed, meets the difficulty level restrictions.
Trading Center