Keynes and the Multiplier Effect

I am cross-posting Jon’s excellent blog on Keynes and the multiplier over at his excellent IB Blog that flags up some handy recent articles on this important macro policy concept:

The Telegraph continues with it series of extracts from Edmund Conway’s new book and today it focuses on the twentieth centuries greatest economist John Maynard Keynes.

In its simplest form Keynesianism argues that governments should be proactive during economic downturns rather than relying upon the power of the markets and interest rate cuts. Proactive in the sense that the government should borrow money and start spending. The doctrine lost favour in the 1970s as monetarist theory gained popularity. As you will be well aware Keynes has returned in earnest over the past 18 months as governments across the globe have pumped billions into the spluttering economies in the hope of restarting them. Although early days there are tentative signs that Keynes may have be right once again.

Key to his argument of the effectiveness of pumping money into an economy is that of the multpier. Conway provides an excellent overview of the multiplier in his piece today:

Say the US government orders a $10bn (£6bn) aircraft carrier. You might assume the effect of this would be merely to pump $10bn into the US economy. Under the multiplier argument, the actual effect would be bigger. The shipbuilder takes on more employees and generates more profits; its workers spend more on consumer goods. Depending on the average consumer’s “propensity to consume”, this could raise total economic output by far more than the amount of public money actually injected.

If the $10bn increase caused total United States economic output to rise by $5bn, the multiplier would be 0.5; if it rose by $15bn, the multiplier would be 1.5.

The article also provides some good points that students could use when being critical of fiscal policy (these were particuarly prevalent when monetarists were arguing against Keynesianism in the 1970s):

One of their main arguments was that governments cannot “fine-tune” an economy by regularly adjusting fiscal and monetary policy to keep employment high. There is simply too long a time lag between recognising the need for such a policy (tax cuts, say) and the policy taking effect. Even if policy-makers speedily identify the problem, it takes time for laws to be drafted and passed, and more time still for the tax cuts actually to drip through the wider economy.

There are a couple of recently published books on Keynes that you may want to get your teeth into:

Keynes: Return of the Master by R Skidelsky

Keynes: The Twenthieth Century Most Influential Economist by P Clarke