I am republishing below a post I wrote trying to explain the multiplier as an effective policy tool embedded in Keynesian deficit finance. It first appeared in my older blog on blogspot Harold Chorney political economist in the middle of the financial crisis.Alongside my post on my current blog on the multiplier it is I think a useful guide.It was posted here on haroldchorneyeconomist as Some notes on the multiplier, April 4, 2012.
The technique of deficit finance
January 17, 2008 11:30 pm
The stimulus package being discussed in Washington will temporarily increase the American federal government deficit in order to inject a positive fiscal impulse to the economy. There seems to be, perhaps understandably, a fair bit of confusion about how such a stimulus can work to counter the recessionary forces now underway in the American manufacturing, housing and financial sectors of the American economy. First one should understand the assumptions that lie behind the theory of deficit finance as well as some statistical facts about the history of deficits and surpluses and the business cycle in the US.
First of all, whenever the government spends on programs or transfer payments more than it takes in in revenues the government will run a deficit. This deficit can be measured and financed in a variety of ways and it can be spent on a variety of programs or tax reductions.In terms of measurement it seems sensible to view expenditures on infrastructure as long term investments and treat them accordingly in the public accounts.
In addition most economists who advocate deficit finance to counter an economic downturn assume that for every dollar spent directly there will be at least another dollar or possibly $.66 of additional spending that will be induced by the original expenditure. Some economists would suggest that the multiplier would be larger others that it would be smaller.
This multiplier is bound up with what is called the Keynesian or more accurately Kahnian multiplier(named after the brilliant British Jewish economist R.F.Kahn who was a very close colleague of Keynes at Cambridge , one of the first economists to develop the idea and who made a major contribution to the General Theory.)
The way that the multiplier works is derived from the mathematical formula for summing up the total of a geometric series. For example let us assume that the series is 1+ v + v(v) + v(v)(v) +….= 1/(1-v) if -1 is less than v and v is less than 1.
(see Robert Barro, Macroeconomics, p.508)
The formula for the multiplier is then 1/1-mpc where mpc is the marginal propensity to consume equivalent to v in the above geometric progression.
In other words the percentage of the last additional dollar you receive that you spend. It also matters where you spend the money. If you spend it on goods and services produced in the country the multiplier is much larger than on goods and services produced elsewhere but sold in the country by a local sales staff. These leakages plus monies received which are not spent but either saved or hoarded are subtractions from the overall multiplier impact.
So lets begin with some statistical facts. The current American deficit is about 1.7 % of the US GDP. The GDP is 13.97 trillion dollars( as of the end of the third quarter 2007) so the deficit is around 244 billion dollars. A 1 % stimulus package would increase the deficit by a further 140 billion, a 2 % package by 280 billion a 3 % package by 420 billion. During the war years 1943, 44 and 45 the deficit rose above 15% of the GDP peaking at over 31 % in 1943. A 3-5 % deficit is very modest indeed in comparison.
If we assumed a multiplier effect of secondary increases in expenditures traceable to the initial injection of 140 billion and a multiplier of 1.5(not all economists would agree that it would be that large, others might suggest it would be larger) the total impact of a one time injection would be $210 billion .
Total accumulated gross Federal debt of 9196.5 billion is currently(the net product of previous deficits and surpluses) 65.7 % of the GDP. During the war years 1942-45 this ratio reached 119 %of the GDP.
To finance this without raising interest rates the Fed Reserve can either buy bonds originally issued by the Treasury but currently held by individuals or financial houses for some of this additional amount thereby creating high powered money that partly offsets the sale of bonds by the Treasury which finances the deficit and then sell some of these bonds to the general community of investors or it can simply expand the money stock. If it does the former however and the financial markets resist the interest rate that the bonds are offered at, the Fed will have to purchase an equivalent further offsetting amount and or inject further high powered money into the system.Later as the economy recovers it can and should withdraw some of the stimulus by selling these bonds back to the investing markets.
(For a thorough discussion of these techniques and the operations of the Fed and the treasury see the work of Robert Eisner , a former president of the American Economics Association and late Professor of Economics at Northwestern University in Chicago where he taught macroeconomics. I had the pleasure of discussing these themes with Eisner in person in Montreal when I brought him to lecture to my students in 1988. Robert Eisner, How Real is the Federal Deficit, pp.131-135.New York;The Free Press, 1986. Eisner’s research and his book was supported by research grants from the National Science Foundation.)
The point is that true Keynesian stimulus involves the scissors effect of a fiscal stimulus financed by by a supportive monetary policy. This is why monetarists like Karl Brunner insist that Keynesianism would only work with the creation of high powered money. But that is a debate for another time.
In the current environment in the financial markets I would think that these bonds will be viewed as highly desirable investments. The more that the Fed purchases the bonds the greater the stimulus however. Strict monetarists will argue that this will also lead to higher inflation in the medium to long run.
Keynesians would not necessarily agree arguing that with a slowing economy and higher unemployment the stimulus will increase largely output rather than prices. Later as unemployment drops some of the stimulus will be transferred to the price side of (P.O i.e.average prices times units of output) at which time the Fed can sell more of the debt to the market.
Once the money is spent on tax rebates, infrastructure projects, food stamps and environmental projects it is received as income by both taxpayers and employees who are hired to work in these projects or who are hired by the private sector who because of the stimulus project have experienced a greater demand for their products or services and have changed their mood from pessimistic contraction to optimistic expansion.
The additional money injected circulates in the economy. Much of it depending on the average marginal propensity to consume will be spent again and recirculate throughout the economy changing expectations from pessimistic ones to optimistic ones.
Investments once postponed will be considered again and a number of them undertaken. As unemployment drops the economy moves from recession to steady growth again.The newly employed both spend their money on goods and service and pay taxes to government. Some of what was spent, but not all, returns to the Federal Government in new tax revenues. As the economy grows larger the debt to GDP ratio provided the interest rates are kept lower than the growth rate in the economy begins to fall.
A little later the actual deficit may well shrink as well.Excess savings that would have subtracted from total aggregate demand because they could not find suitable safe and attractive investment opportunities will now be effectively channelled into attractive investment opportunities.
The stock market beset by uncertainty and insecurity will also begin to experience bullish sentiments. The unemployment rates will drop perhaps by as much as 1 % point as over a million and a half new jobs
are added to the labour force. If the jobs pay on average 40-50,000 dollars the federal and state governments will reap substantial additional tax revenues to help reduce the cost of the stimulus package.
The stimulus package will have done its work.
What might go wrong ? Well the multiplier might be smaller because of leakages to foreign imports. Recipients of the tax rebates might decide not to spend their rebates trying to save them instead, less likely if the rebates disproportionately target moderate and low income people. The Fed may cause interest rates to rise by trying finance the deficit too quickly in the bond markets.
Financial journalist might write influential articles that convince people that the stimulus package won’t work and that interest rates will rise and inflation will result.
Here the collective wisdom of the public which is somewhat more Keynesian than the financial journalists will cancel out most of this kind of negative journalism.
Keynesian rational expectations rather than monetarist ones should prevail !
But for the moment if the members of Congress seize the day and the President co-operates and the package is large enough to do the job, the US can once again demonstrate western leadership in economic policy making that will have far reaching positive consequences.