What is the Keynesian multiplier? September 7, 2016 – The Economist

When Barack Obama sought to boost America’s Keynes’s thinking upended economic ailing economy with a fiscal stimulus package policymaking. It did not settle the debate, worth more than $800 billion in the wake of the however. The Keynesian consensus fractured in financial crisis of 2008, a fierce debate ensued. the 1970s in the face of criticism from new Some economists reckoned the spending would intellectual camps within economics. The do little to help the economy. Others suggested “rational expectations” school, led by Robert it could add much more than $800 billion to Lucas, argued that fiscal policy would be GDP. These arguments centred on the value of undermined by forward-looking taxpayers. the Keynesian multiplier, which determines by They should understand that government how much output changes in response to a borrowing would eventually need to be repaid, change in government borrowing. (With a and that stimulus today would necessitate higher multiplier of two, for example, GDP rises by $2 taxes tomorrow. They should therefore save when the deficit increases by $1.) The income earned as a result of stimulus in order to Keynesian multiplier is one of the have it on hand for when the bill came due. The fundamental—and most controversial— multiplier on government spending might in fact concepts in macroeconomics. Where did it come be close to zero, as each extra dollar is almost from and why is there so much disagreement entirely offset by increased private saving. The about it? backlashes led to the emergence of “New Keynesianism”. Its adherents, among whom are The multiplier emerged from arguments in the many of the leading economic policy-makers of 1920s and 1930s over how governments should the past few decades, typically hold that respond to economic slumps. John Maynard monetary policy is a more powerful and Keynes, one of history’s most important efficient macroeconomic tool than fiscal economists, described the role of the multiplier stimulus. When central banks do their job in detail in his seminal book, “The General correctly fiscal policy is unnecessary, they Theory of Employment, Interest and Money”. argue; monetary corrections should cancel out Conventional wisdom had it that government the effects of fiscal expansion or contraction, borrowing raises interest rates and uses squishing the multiplier to near zero. resources which might otherwise have been spent by private firms or households. Keynes The financial crisis led to a reawakening of old agreed that this could be the case in normal Keynesian ideas, however. Scores of papers times, but he also argued that when an economy have been published since 2008 attempting to is operating below full employment, how much estimate fiscal multipliers. Most suggest that, is spent determines the levels of investment and with interest rates close to zero, fiscal stimulus income rather than what the economy is capable carries a multiplier of at least one. The IMF, for of producing. During such slumps, stimulus instance, concluded that the (harmful) multiplier provided by the government does not crowd out for fiscal contractions was often 1.5 or more. private activity, because the economy is Even as many policymakers remain committed operating below capacity. Instead, it ripples to fiscal consolidation, plenty of economists across the economy, boosting the incomes of now argue that insufficient fiscal stimulus has those who receive government contracts or been among the biggest failures of the post- benefit payments, who then go on to spend and crisis era. Decades after its conception, invest more. Should the government cut back, Keynes’s multiplier is relevant, controversial the ill effects would multiply in the same way. and ascendent.