Keynesian Autopsy: Part 4- Fiscal Policy

 

Keynesian Economics and Fiscal Policy

The multiplier effect, developed by Keynes’s student Richard Kahn, is one of the chief components of Keynesian countercyclical fiscal policy. According to Keynes's theory of fiscal stimulus, an injection of government spending eventually leads to added business activity and even more spending. This theory proposes that spending boosts aggregate output and generates more income. If workers are willing to spend their extra income, the resulting growth in the gross domestic product( GDP) could be even greater than the initial stimulus amount.

The magnitude of the Keynesian multiplier is directly related to the marginal propensity to consume. Its concept is simple. Spending from one consumer becomes income for a business that then spends on equipment, worker wages, energy, materials, purchased services, taxes and investor returns. That worker's income can then be spent and the cycle continues. Keynes and his followers believed individuals should save less and spend more, raising their marginal propensity to consume to effect full employment and economic growth.

In this theory, one dollar spent in fiscal stimulus eventually creates more than one dollar in growth. This appeared to be a coup for government economists, who could provide justification for politically popular spending projects on a national scale.

This theory was the dominant paradigm in academic economics for decades. Eventually, other economists, such as Milton Friedman and Murray Rothbard, showed that the Keynesian model misrepresented the relationship between savings, investment, and economic growth. Many economists still rely on multiplier-generated models, although most acknowledge that fiscal stimulus is far less effective than the original multiplier model suggests.

The fiscal multiplier commonly associated with the Keynesian theory is one of two broad multipliers in economics. The other multiplier is known as the money multiplier. This multiplier refers to the money-creation process that results from a system of fractional reserve banking. The money multiplier is less controversial than its Keynesian fiscal counterpart.