The Economist explains
This week, “The Economist Explains” is devoted to the economy. For each of the six days through Saturday, this blog will post a brief explainer on a basic idea.
WHEN Barack Obama sought to stimulate the struggling US economy with a fiscal stimulus package worth over $ 800 billion in the wake of the 2008 financial crisis, a fierce debate ensued . Some economists have estimated that the spending will do little to help the economy. Others have suggested it could add well over $ 800 billion to GDP. These arguments centered on the value of the Keynesian multiplier, which determines by how much output changes in response to a change in government borrowing. (With a multiplier of two, for example, GDP increases by $ 2 as the deficit increases by $ 1.) The Keynesian multiplier is one of the fundamental – and most controversial – concepts in macroeconomics. Where does it come from and why is there so much disagreement about it?
The multiplier emerged from arguments of the 1920s and 1930s about how governments should react to economic downturns. John Maynard Keynes, one of the most important economists in history, described in detail the role of the multiplier in his seminal book, “The General Theory of Employment, Interest and Money”. It is generally accepted that government borrowing raises interest rates and uses resources that might otherwise have been spent by private companies or households. Keynes agreed that this might be the case in normal times, but he also argued that when an economy operates below full employment, what is spent determines investment and income levels rather than what is spent. economy is capable of producing. During such crises, stimulus measures provided by the government do not crowd out private activity because the economy is functioning below capacity. Instead, it spills over into the entire economy, increasing the incomes of those who receive government contracts or benefits, who spend and invest more. If the government scaled back, the harmful effects would multiply in the same way.
Keynes’ thought changed the development of economic policy. However, that did not settle the debate. The Keynesian consensus fractured in the 1970s in the face of criticism from new intellectual camps in the economy. The school of “rational expectations,” led by Robert Lucas, argued that fiscal policy would be undermined by forward-looking taxpayers. They need to understand that government loans will eventually have to be repaid and that today’s stimulus will require higher taxes tomorrow. They should therefore save the income from stimulus measures in order to have them on hand when the bill is due. The public expenditure multiplier could in fact be close to zero, as every additional dollar is almost entirely offset by an increase in private savings. The backlash led to the emergence of “New Keynesianism”. Its proponents, including many of the key economic decision-makers of recent decades, generally believe that monetary policy is a more powerful and effective macroeconomic tool than fiscal stimulus. When central banks do their job well, fiscal policy is not necessary, they argue; monetary corrections should cancel out the effects of fiscal expansion or contraction, reducing the multiplier to near zero.
The financial crisis, however, led to a revival of old Keynesian ideas. Dozens of articles have been published since 2008 in an attempt to estimate budget multipliers. Most suggest that with interest rates close to zero, the fiscal stimulus has a multiplier of at least one. The IMF, for example, found that the (harmful) multiplier of fiscal contractions was often 1.5 or more. While many policymakers remain committed to fiscal consolidation, many economists now argue that inadequate fiscal stimulus has been one of the biggest failures of the post-crisis period. Decades after its conception, Keynes’ Multiplier is relevant, controversial, and bottom-up.
Previously in this series
Monday: Akerlof lemon market
Tuesday: The Stolper-Samuelson Theorem
Wednesday: Nash’s Balance
To come up
Friday: Minsky’s financial cycle
Saturday: The Mundell-Fleming Trilemma
In the last few weeks The Economist published two-page memoirs on six fundamental economic ideas. Read the full Keynesian Multiplier dissertation, or click here to download a PDF containing all six articles.