Can Government Successfully Counter Recessions Through Expansionary Policies? Don’t Count on It
Whenever the signs of an economic weakness emerge, most economic and political commentators declare that the government should increase spending in order to prevent the economy falling into a recession. Economic activity, in this view, consists of a circular flow of money, with one individual’s spending becoming part of the income of another individual. Spending equals income, hence more spending will mean higher incomes.
If some individuals decide to reduce their spending, their actions weaken the circular flow of money. If an individual spends less, the incomes of others are lessened and they, in turn, reduce their purchases of goods from other individuals. As a result, overall spending on goods and services declines and, thus, overall income falls, too.
Following this logic, in order to prevent a downward spiral, mainstream economists claim the government should step in and increase its outlays, thereby filling the shortfall in private sector spending. Thus, government spending is a vital agent of economic growth.
The Magic of the Keynesian Multiplier
John Maynard Keynes popularized the view that an increase in government outlays causes the economy’s income to increase by a multiple of the initial government increase. The following example illustrates the essence of this way of thinking.
Assume that in order to strengthen the pace of economic activity, the government decides to increase its expenditure by $100 million. Assume also that out of each additional dollar received, individuals spend ninety cents and save ten cents.
Once the government increases its outlays, the amount of money in individuals’ possession increases by $100 million. Given that individuals spend ninety cents of an additional dollar received, this means that they are going to spend 90 percent of the $100 million, so they will increase expenditure on goods and services by $90 million.
The recipients of this $90 million in turn spend 90 percent of the $90 million, which is $81 million. Then, the recipients of the $81 million spend 90 percent of this sum, which is $72.9 million, and so on. Note that the key in this way of thinking is the belief that the expenditure of one person becomes the income of another person.
At each stage in the spending chain, individuals spend 90 percent of the additional income they receive. This process eventually ends, with total income higher by $1 billion than it was before government increased its expenditure by $100 million, with the multiplier being 10 ($100 million x 10 = $1 billion). Observe that the more of the additional income is spent, the greater the multiplier is going to be and, therefore, larger the impact of the initial spending on the overall income.
For instance, if individuals change their habits and spend 95 percent of each dollar, the multiplier is going to become 20. Conversely, if they decide to spend only 80 percent and save 20 percent, then the multiplier is going to decline to 5. This means that the less individuals save, th
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