Chapter Fourteen

Animal Spirits

The General Theory of John Maynard Keynes

John Maynard Keynes

John Maynard Keynes (June 5th, 1883 – April 21st, 1946) was an English economist whose ideas fundamentally changed the theory and practice of macroeconomics and the economic policies of governments. Originally trained in mathematics, he built on and greatly refined earlier work on the causes of business cycles. One of the most influential economists of the 20th century, his ideas are the basis for the school of thought known as Keynesian economics, and its various offshoots.

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John Maynard Keynes, who went by Maynard to his friends, deserves a brief biographical sketch before we dive into his radical ideas about the economy. It would be right to say that Macroeconomics, as a discipline of study distinct from Microeconomics, did not exist before Keynes. There was no systematic inquiry into the causes and consequences of the business cycle before Keynes, just a loose collection of thoughts and ideas. In the same way that the orthodoxy of the Ancient Greek thinkers like Plato and Aristotle had to be excised by revolutionary new thinking during the Enlightenment, such as by the writings of Adam Smith, now the orthodoxy of classical economics had insulated itself from criticism and was freezing the hands which might be able to counter the boom-and-bust cycle of the economy. Keynes’ contributions in overturning some of that thought make him one of the most influential thinkers of the 20th century. --Keynes was born in 1883 in Cambridge, England to parents who were both academics. He was raised in a middle-class household, and was of course well educated himself, attending the famous Eton College and then King’s College, Cambridge. While there, Keynes became involved with a group of friends that would come to be called the Bloomsbury Group which included the author Virginia Woolf, her husband Leonard, the author E.M. Forster, and the painter Duncan Grant among many others who became important literary or artistic figures and public intellectuals. Keynes met Duncan Grant in 1908, and the two became romantically involved for many years. For most of Keynes’ life he was romantically involved only with other men, and the Bloomsbury group was well ahead of its time in acceptance of homosexuality and feminist thought. Keynes surprised them all though and himself when he fell for a Russian ballerina named Lydia Lopokova in 1921, whom he married and by all accounts it was genuine love. His relationship with the other members of the Bloomsbury Group, which was focused primarily on art and literature, would profoundly influence his economic work. --In 1930, Keynes published a paper called The Economic Possibilities of our Grandchildren. In a time of doom and gloom, Keynes suggested that the future still looked bright, and that growth would continue. He predicted that 100 years later in 2030, incomes would have grown exponentially, and would be 4 to 8 times higher. We are right on track for the middle of that prediction. 1930 GDP per Capita, adjusted for inflation to 2020 dollars, was $12,258. Actual GDP per capita in 2020 was $63,543. If real GDP per capita keeps growing by about 2% each year, we will end up a little over a six-fold increase by 2030. Just like we did when we imagined what economic growth would mean for humanity after a few centuries, Keynes thought this level of income would finally free people from economic problems. He wrote, “Thus for the first time since his creation man will be faced with his real, his permanent problem — how to use his freedom from pressing economic cares, how to occupy the leisure, which science and compound interest will have won for him, to live wisely and agreeably and well.” Seeing the trends in the workweek, he predicted we would all be working about 3 hours a day on average, for a 15-hour workweek. He might have underestimated our willingness to put off the question of how to keep from being bored by willingly keeping the 40-hour workweek, but if what I hear from friends and relatives and my own life, time spent actually getting work done might not be so far off from Keynes’ estimate. Keynes is the perfect person to serve as the main character of our course. Like the other members of the Bloomsbury group, he challenged the orthodoxy and prized new ways of thinking. He was optimistic, and valued liberty and dignity for commerce. And he saw the project of economics as working towards the liberation of humankind from scarcity. But he believed this meant something different than making people infinitely wealthy. Instead, the goal is to offer everyone the chance at the Good Life, full of enriching social relationships, appreciation of art for art’s sake, and the accomplishment of work that is personally rewarding rather than work done strictly for public praise. And, of course, because Keynes is considered by all who study it to be the father of macroeconomics. --Keynes studied under Alfred Marshall – the economist responsible for the supply and demand framework that defines the entire discipline – who begged Keynes to abandon his pursuit of philosophy in order to become an economist. Keynes obliged, and early in his career he began working for the British government. His brilliance was identified by all, and he quickly became an important figure in the government. At the beginning of World War I, he helped steer the British financial markets through the immediate international crisis, and as we have already covered, he tried his best to steer the entire continent towards a lasting peace, but ultimately spoke against the treaty with his book The Economic Consequences of the Peace. At the same time, Keynes had an academic career with King’s College, Cambridge. In the 1920s he was put in charge of the college’s endowment. He made some unwise investments at first, but quickly found his feet and an investment strategy that not only worked for the college but for his own finances. He was an early pioneer of diversifying a portfolio, and engaged in value investing, searching for stocks which appeared fundamentally underpriced. He made his own fortune which he used to buy a newspaper that could then employ his friends in the Bloomsbury group. He lost it all in the Great Crash of 1929, even having to go so far as borrowing money from his parents to get by but managed to build it back over a few years. By the time he died his fortune was the equivalent to about $30 million today. Keynes was a lifelong member of the British Liberal Party, and through his connections and newspaper he had enormous influence in defining the party’s ideology. He was a strong supporter of woman’s rights and outspoken about the need to reform the laws against homosexuality. Unfortunately, like many intellectuals of his day, Keynes was a proponent of eugenics, and did not come to see the error of his ways. After The Economic Consequences of the Peace, Keynes was a bit of an outcast from official government work. He turned his attention to his economic writing, and in the decade prior to the Great Depression, he started building the foundation of what would become his greatest work, The General Theory of Employment, Interest, and Money, which he published in 1936. World War II made him indispensable to the British government again, and unlike World War I – from which Keynes was spared from fighting as a conscientious objector to the war – Keynes believed it was incumbent on the world to actively defeat Nazism. After the war, Keynes helped restructure the system of international finance with the Bretton Woods Agreement, named for the place in New Hampshire where it was negotiated, which placed the American dollar, rather than gold, as the reserve currency of the world. --Keynes died in 1946 at the age of 62 after a series of heart attacks. His ideas had already become the mainstream school of thought among economists, and his influence on economic thinking would only grow from there. When we look back to the time before and during the Great Depression, there is an ethos which is unfamiliar to us today. We wonder how and why President Herbert Hoover didn’t do more for the economy during his term, and why voters were so resistant to the interventionalist policies proposed by William Jennings Bryan. In America we had Franklin Roosevelt, who overturned that idea for us, but the rest of the world had John Maynard Keynes. And without his intellectual backing of the ideas, it’s likely that Roosevelt would not have been able to do as much as he did. It’s pretty likely that some of the ideas about the relationship between the government and the economy you hold in your head now originated in the mind of John Maynard Keynes. When Time magazine included Keynes among its Most Important People of the Century in 1999, it stated that "his radical idea that governments should spend money they don't have may have saved capitalism."

A General Glut

Adam Smith's great insight was that when people are left to make their own economic decisions, without the undue influence or coercion of government, then they will make the choices which result in the best possible use and allocation of our resources. This idea had been embraced by the industrialized world, and a century of scholarship had been done to bolster its claims. But the Great Depression, and the other downturns which came before, seemed at odds with this conclusion. There were periods of time where the economy was clearly not reaching the best possible use and allocation of our resources (consider the resource of labor and the millions left desperate for work). To make headway on the problem of the business cycle, Keynes first needed to identify the problems with the Classical school of thought in economics.

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Let’s review and add a little depth to the Classical School of economic thought which was predominant before the Great Depression. The Classical Economists like Jean-Baptiste Say thought that economic forces – or the incentives that people face – will automatically guide them to a sustainable amount of production. It was Keynes – mostly in an effort to paint this idea as ridiculous – who characterized Say’s Law as “supply creates its own demand.” But what Jean-Baptiste Say really meant was that it doesn’t make sense for people to overproduce or underproduce, and so doing so for an extended period of time shouldn’t occur. In the language of Keynes, Say was claiming that a general glut in the economy could not occur. Think of a tree farm consisting of many thousands of trees. Ideally, if we want to manage this resource sustainably, we would cut down trees at a rate so that when we get to the end of our farm, the trees we cut down at the beginning have grown back. If we go too slowly, we are leaving something on the table. We could have more wood and paper and other tree-based products without losing anything, because trees will just be sitting there, and wise entrepreneurs will move in and get things up to speed in order to capture the profits that can be made there. If we go too fast, we will end up with a lot of wood and paper and stuff for a short, glorious period of excess, and then we’ll run out of trees, and we will just have to sit there and wait in a desolate wasteland of nothing until they grow back. Not very smart. A wise entrepreneur will see this tree apocalypse coming, and they’ll want to take ownership of some trees and save them for the time we run out and people get desperate. Of course, that’ll just slow down our tree cutting, and by no fault of their own, those entrepreneurs seeking to capitalize on our despair will end up preventing it from ever happening. Incentives drive people to use resources responsibly. It is more profitable to use them responsibly. So why wouldn’t they? And this production should produce enough income to support its own purchase. If it didn’t, it wouldn’t be the sustainable amount of production. --Driving Say’s Law is the idea of self-correcting markets. Especially the market for loanable funds and the labor market. The market for loanable funds, or the credit market, sets interest rates which equilibrate savings with lending. Thus, all savings should become investment. Hoarding cash is irrational. If you are planning to save your cash, why wouldn’t you want to earn interest on it? The market coordinates time with interest, and rewards those who save their cash. There is no value in having money sit there, and so all of those savings will be lent out for investment. This means that any income you don’t go out and spend yourself will still be spent, because the person borrowing it will spend it, ensuring there is enough demand in the economy to go with supply. And in the labor market, wages should adjust to eliminate unemployment. Cyclical unemployment means there is a surplus of labor. More people want a job at the going wage than there are jobs available. The excess supply will push wages down, and those with alternative options will take them until all those who want to work will find a job. There might still be some frictional unemployment and structural unemployment, but those don’t reflect an economy leaving the valuable resource of labor on the table. --Then there is the quantity theory of money. It’s an equation which is true by definition: M times V is equal to P times Y. M is the money supply. V is the velocity of money, or the number of times each dollar gets spent on average. So, M times V is the total amount of money that gets spent in a year. If you know how many dollars there are, and you know how many times each dollar got spent, you know how much spending happened in total. That will be equal to the price level, or the average price of final goods and services, times output, or real GDP, representing the amount of final goods and services produced and purchased. If I know the average price of what was bought, and the amount of stuff that was bought, then I know the total amount of money spent on these things. Essentially this equation says that the total amount spent on stuff has to be equal the total amount paid for stuff. Ya… of course. But it is also useful in thinking about how things might change. The money supply is determined by the monetary base, the amount of money in circulation, and by credit markets. Remember, banks essentially create money through the process of lending, and the reserve ratio sets that money multiplier. Fluctuations in the credit market, as seen in most financial crises, can create big fluctuations in the money supply. Output, on the other hand, is determined by resources and technology. It doesn’t matter how big the numbers we print on our money are. How much we produce depends on the resources we have and the technology available to turn those resources into stuff. This is really the lesson of Say’s Law. So, there is this disconnect between the money supply and output. Changes in the money supply shouldn’t have an impact on output, a claim known as money neutrality. This means that any fluctuations that happen on the left side of this equation, in M or V, will result in changes only in the price level, P. In other words, changes in the money supply result in inflation or deflation. Not in contractions or expansions in output. --But the experience of the Great Depression flies in the face of these claims. How can one look at the evidence and claim that a general glut is not possible? How can one observe the mass unemployment of desperate job seekers willing to take any work that came their way and say that markets are self-correcting? Clearly, Y is changing.--Such went the opening chapters of John Maynard Keynes’ General Theory of Employment, Interest, and Money. No one had really bothered to assemble a consensus view on the economy which could explain the business cycle until Keynes did. And so, Keynes himself is really the author of the Classical school of thought. And he assembled it merely as a necessity in order to knock it down. --Keynes rejected Say’s Law of Markets, claiming instead that it was demand which created supply. He also argued that markets did not self-correct quickly, and monetary leakages, like people withdrawing their money from banks in fear and stuffing it under their mattress, would disconnect savings from investment. Further, prices and wages resisted pressure to go down. No one likes getting or giving a wage cut, and so firms will avoid doing so. With those frictions preventing a change in the price level, the impact of fluctuations will fall on output. Keynes argued that it just wasn’t right to assume that human behavior would be consistent with these broad assumptions of rationality and impetus towards efficiency. He wrote, “Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits—a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.”In other words, Keynes was saying that the invisible hand was not going to guide an economy to recovery.

The Paradox of Thrift

Keynes put emphasis on the demand side of the market. Without enough demand for goods and services, firms would reduce their production not only now, but also their planned production for the future. Unless firms saw a return in that demand, they would resist increasing supply and hiring people back. This means that recessions could become self-fulfilling prophecies. The fear of a coming recession might cause people to pull back on their spending, and in doing so, trigger the cutback in production that plunges the economy into a downturn.

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One of the key insights economists had already made about the economy is that money is always moving. The circular flow model of income is a representation of that movement which helps us to see how the flow of money helps support the entire economy. In a capitalist economy, households are the owners of the factors of production. Firms purchase those factors - land, labor, capital, and entrepreneurship - from households, which becomes the income those households earn in the form of rent, wages, interest, and profit. Our total national income is usually represented by the letter Y. Households then have choices about what to do with their income. They can buy the goods and services firms produce with those factors of production, which is consumption, represented by C. Or they can use that money to pay taxes to the government or save. The savings go into the banks, where financial markets use the savings to make loans to businesses for investment expenditures (represented by I), and governments use taxes for government expenditures (G). All of that spending, C, I, and G, goes back to the firms who produce the goods and services, the capital purchased by investment, and the things the government purchases. Together, they total up to our national income, or GDP. And if we add the Overseas Sector, where we can buy and sell with other countries, we just need to add the net exports to get our familiar GDP equation. Let’s see how this works in the circular flow model. Let’s start with six piles of cash with the firms. They use this money to pay for the factors of production they need to make goods and services, which becomes income for the households. This means our national income, or GDP, is 6 piles of cash. Now households divvy up that income for their various purposes, such as buying consumer products from firms, saving money in the financial markets, paying their taxes, and perhaps even buying some consumer products made in other countries. But now we have a problem. There isn’t enough money with the firms to support our national income of six piles of cash. They only have three piles of cash with which to buy the factors of production. The insight of the circular flow model is that the structure of the economy will send the other three piles of cash to the firms. The financial markets will make loans to firms, which they will use for investment expenditures. Those expenditures are spent on the products made by other firms. If someone takes out a loan to open a restaurant, they spend it to buy tables and chairs, kitchen equipment, and other items produced by other firms. And the taxes the government collects are spent on still more products made by firms, such as asphalt for roads, agencies which act as firms, and even simple things like paper for their printers. And the US dollars we bought products with from overseas will also eventually find their way back to the US, purchasing our exports or paying for investment expenditures, as we know from the balance of payments. All the money flows back to firms, which means there will be enough to continue to support our national income. --The flow of money is always in motion, moving from one sector of the economy to another, but never idle and always enough to support the level of production that is possible based on the resources we have and the technology available to turn them into stuff. This is really just a representation of Say’s Law of Markets. Supply will create its own demand. --But Keynes pointed out that there was a way to reduce demand that does not originate from a reduction in supply. Firms can pay households, and households could do their usual spending. But if, for some reason, they don’t trust the financial markets to keep their savings intact, they might just sit on the money, meaning that it never makes it back to the firms and the firms see a drop in demand for the goods and services they produce, meaning they won’t earn enough to support the same level of production. Without enough demand, they will have to lay people off and slow production, reducing our national income and plunging us into a recession. --When money slips out of the circular flow like this, we call it a liquidity leak. But don’t confuse this problem with people not spending their money. If a family earns some income, and they choose not to spend it, they are usually wise to save it in some kind of interest-bearing account or otherwise just leave it in a bank for safe keeping. That bank is the intermediary which turns the lack of consumer spending to an increase in investment spending by loaning the money to firms, who then do the spending that is needed to keep the income flowing to the family. But when a panic arises, and people don’t feel safe keeping their money in the banks, the financial system crumbles, and with it goes investment spending, and with that goes incomes. Keynes believed the key to keeping the economy running smoothly is to keep the circular flow of money going. --Keynes called this the Paradox of Thrift. The circular flow of income should ensure that there is enough money to support the production we are capable of and keep us at full employment. But when people are thrifty, and choose to stop spending so much money, what remains in circulation is not large enough to support full employment, and people have to be laid off. Keynes argued that even if the money ends up in a bank, there is no guarantee that it will be lent out for investment. In troubled times, banks might increase their reserve ratios, and keep more cash on hand in case a panic ensues, but in doing so they end up creating the panic. The Paradox of Thrift is that the prudent measures we might take to prepare for a downturn in the economy such as saving a little more or taking fewer risks, end up causing the downturn. But this alone is not enough to explain why we would get stuck in a downturn. When there isn’t enough money in circulation, deflation should cause prices to drop to fit the constraints. For example, in round two of this economy, why not split the five piles of cash six ways, and charge 1/6 less for all the goods and services? If we just did that, everyone would be employed, they could all still afford the same things they were buying before, and the economy continues on as normal at the lower price level. So, why weren’t people doing this?

Sticky Prices & Wages

It can't just be low demand though. That isn't enough. If demand is low, prices should drop until the money still in circulation is enough to support the full employment level of production. In order for the Keynesian explanation for recessions to be right, there needed to be something preventing prices and wages from adjusting to the circumstances of the economy.

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Let’s imagine a simple economy that only produces hamburgers. The economy has the resources and technology to produce 100 burgers. Further, there is $500 in the money supply. For the sake of an easy example, we are assuming the velocity of money is 1, so each of the $500 only gets spent once. That means our $500 of total spending is divided among 100 total burgers, so the price of each burger is $5. And the $5 paid for each burger will be divided up amongst all the contributors. I have it split up this way: $1 per burger to the workers, $1.50 to the land and natural resources used, $2 to the capital needed to make the burger, leaving $0.50 for the entrepreneur who owns the business to take as profit. The $5 could be split up any which way, but this is how I did it for our example. Now, the amount of money paid isn’t really what’s important here. What is important is how much you can buy with that money. In our example economy, the only thing there is to buy is hamburgers. The workers, making $1 per hamburger, will get $100 total after all 100 burgers are sold. That means collectively the workers can afford to buy 20 burgers with that $100 of income. Similarly, with the $150 total paid to the resource owners after selling all 100 burgers, they can buy 30 burgers. The capital owners have $200, so they can afford 40 burgers. And the owners of the business can buy 10 burgers with their profits. These are their real incomes. They describe how much a person can afford. --So now let’s say that there is a reduction in the money supply because people withdraw their money from banks, and the reduction in lending reduces the money multiplier and the money supply. Now there is $400 in the money supply. Here is what should happen. The price of the burgers has to fall to $4 each. We still have the same number of patties and buns and pickles and cheese. We can still make 100 burgers. It doesn’t matter that there is less money in circulation, that doesn’t change the number of resources we have. However, with a lower price paid for burgers, the payments made to each factor of production have to come down too. The deflation doesn’t just impact the price level of the burgers, it also shows up in people’s paychecks. Workers get $0.80 per burger, resources owners get $1.20 now, capital owners get $1.60, and the owners get $0.40. But look, they can still afford the same number of burgers as before. Workers get $80 total, which is enough to still buy 20 burgers now that they are only $4 a piece instead of $5. Sure, the price tags change, the paychecks changed, and the economy went through some deflation, but it doesn’t matter. It doesn’t affect what the economy produces, how it produces it, or who gets it. The real economy is still the same. --But what happens if the prices didn’t change. What if the money supply went down to $400, but the burger still cost $5, and everyone was still paid the same? Well, even though we have the resources to produce 100 burgers, we don’t have the money to afford them anymore. The most this economy could buy is 80 burgers. And that means the number of burgers everyone is getting has to come down too. They can’t end up buying more burgers than are being produced. And the drops here are driven by resources going unused. In this economy, 20% of our resources are not being used, which would mean we have a 20% unemployment rate here, and our economy has sunk into a horrible recession. If prices and wages are sticky, meaning they don’t change, they are stuck in place, then the reduction in the total amount of spending on our economy – our economy’s total demand – will result in a severe contraction in output. But why would this happen? Why don’t prices adjust? Isn’t this what the invisible hand is there to do? The forces of supply and demand are supposed to guide these prices and wages to their appropriate equilibrium where everything works out just fine. --But remember, by the time the Depression happened, the economy didn’t work that way anymore. It was no longer a collection of tiny household firms adding value in small stages across a long chain of production orchestrated by the invisible hand of the market. Now production was dominated by multi-unit enterprises which consolidated those many stages of production under one roof. These large firms traded some cost efficiency for better administrative coordination. They gave up the efficiency of the price system in order to streamline production processes and the trade-off was good for the bottom line. Having fewer large firms, rather than many small firms, reduced competitive pressures. And bigger profit margins meant that they could survive even if they didn’t adjust prices. They could get away with keeping things stuck in place for a while without worrying about the forces of competition sweeping them out of the economy immediately due to the slightest bit of inefficiency. And remember too, with the rise of the big firm came the rise of labor unions, which organized workers and allowed them to bargain for higher wages at the expense of even more inefficiency. Unions, more than firms, had a stake in trying to keep wages from dropping in the face of deflation. --It was John Maynard Keynes’ colleague and close friend, the economist Joan Robinson, who pioneered this work on imperfect competition. Three years before Keynes published his General Theory, she published The Economics of Imperfect Competition, outlining how wages could get stuck, and this was a major influence on Keynes. When demand falls throughout the economy, it reduces the demand firms have for labor. A reduction in demand means it shifts to the left, and the pressures of competition are supposed to push the market to a new equilibrium at a lower wage. But frictions in the economy due to large firms and labor unions each with market power keep the wage level stuck in place. At this higher wage, the quantity of labor demanded falls far short of the number of workers seeking a job. The surplus in workers manifests in the economy as cyclical unemployment, just as was seen during the Great Depression. Where the Classical School of thought said widespread involuntary unemployment could not last long, because markets were self-correcting, Keynes and Joan Robinson were building an entirely new framework for the economy which showed – predicted even – that such unemployment could and would happen. --But experience also showed that prices were not as sticky as claimed. When the money supply drops as it did in our example, experience showed that the price level would drop right along with it. But the payments made to some of the factors of production wouldn’t, and the burden of deflation would fall on profits, which would sink. If the owner of this business is losing money on every burger, burger production doesn’t fall just a little, it falls all the way. The firm shuts down, and everyone involved ends up unemployed. During the Great Depression, the money supply fell by 25-30%, and the price level – here corresponding to the price of the hamburger – fell by almost 25%, just like the Classical School would have predicted. But wages only fell by 11 to 17%, far short of where the predictions of Say’s Law, self-correcting markets, and the quantity theory of money would make. Indeed, something in the economy was stuck, and it was causing a great deal of trouble with no obvious way out.

The Expenditure Multiplier

Keynes had outlined how an economy could fall into a recession (the paradox of thrift) and why an economy might not be able to recover from a recession quickly (sticky prices and wages). Next, Keynes outlined a solution to the problem, which was based largely on his time spent as a government official, actively interfering in the economy in order to stave off disaster. Unlike so many economists before, who rightly saw the government as an impediment to the economy, Keynes saw the potential for the government to be the solution.

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According to Keynes, people driven by animal spirits to action would be thrifty when they were worried about the economy, pulling their money out of the circular flow and bringing on the downturn they feared. With sticky prices and wages, the deflationary spiral would wreak havoc on business, and production would sputter to a halt in many sectors of the economy, leaving huge chunks of the labor force unemployed while banks packed their vaults with money rather than lending it out. The thriftiness dried up the consumer demand, and uncertainty stopped banking from making up the difference by financing investment spending. These idle resources were just left unused by a broken economy that wasn’t going to be able to heal itself until either the consumer spending or the investment spending rose to the occasion, and that wasn’t going to happen so long as the uncertainty about the future continued. --Adam Smith and his contemporaries had ushered in an era of prosperity by calling for economic freedom and laissez-faire policies that kept the government from getting involved. The incredible success of those ideas cannot be denied. But the economy that rose up around those ideas was not as efficient and self-correcting as it seemed. It was prone to fluctuations in credit driven by banking panics that made investment spending unpredictable. The first response was to try and shore up those financial markets, and back them with a central bank, but laissez-faire thinking was so strong even the Fed balked at the level of intervention that might be required of them. What Keynes delivered was an intellectual framework for rethinking those presumptions. He was influenced by the commonsense philosophy practiced by Bertrand Russell and G.E. Moore, and his work changed the minds of the ruling class while Franklin Roosevelt was pressing forward with or without them on the same ideas. --What Keynes was proposing was a program of countercyclical fiscal policy engineered by the government. When the economy was booming, governments should swing the other way by raising taxes and lowering government spending. Higher taxes would push down over-zealous consumer spending while reduced government spending would counter excess in investment spending and keep the government’s finances in order, running a surplus of funds to be saved for later when the economy entered a recession. That’s when the government was advised to cut taxes – encouraging consumer spending – and to raise government spending. This would mean a budget deficit which would be covered by borrowing the idle funds sitting in banks which ought to be going to investment spending. In essence, if the problem in a recession is too much saving and not enough investment, the government could cover the extra savings by lowering taxes and take over the role of investment through government spending. Once the economy got going again, and we reached another economic boom, the government would swing the other way once again, and pay down their debts by running a budget surplus. The objection many had was whether or not the government could even manage this. In the 1930s, government spending was only about 10% of GDP. The Great Depression shrunk the economy by half, and many questioned if it was even possible for government spending to make up that difference and not end up bankrupting itself, making the crisis even worse. --But the key to Keynes’ idea was that resources were idle, and so the government would only need to spend a small fraction of what was needed to make up the difference. The Marginal Propensity to Consume (MPC) is the portion of new income a typical person spends on consumption, as opposed to saving it. When anyone spends money, it ends up as income for someone else, who will spend some portion of it themselves, becoming income for another person, and on and on this goes. The initial spending kicks off a chain reaction of additional spending. It may be that some people spend everything they earn while other spend very little, choosing to save most of what they earn, but aggregated together, the overall economy is spending some fraction of the additional income earned, and that means we can use a similar shortcut to figuring out the impact of an additional dollars’ worth of spending on the overall economy. --The expenditure multiplier is that shortcut. The expenditure multiplier tells us how much $1 of initial spending will increase GDP. To find the expenditure multiplier, all you need to know is the marginal propensity to consume, or MPC. The formula is 1 divided by 1 minus MPC. Here is an example. If the government borrows and spends an additional $5 billion – like they did with the Works Progress Administration during the Depression – and the marginal propensity to consume is 75% - meaning people typically spend $0.75 for every additional dollar they earn, a reasonable estimate for the time – what impact will it have on GDP? The expenditure multiplier would then be 1 divided by 1 minus 0.75, which works out to 4. The multiplier is the thing you multiply the spending by, and so we take the $5 billion in spending and multiply it by 4 to get a total effect of $20 billion. So, for every dollar the government spent, GDP rose by $4. --The expenditure multiplier isn’t a magic wand. During normal times, with a healthy economy, an increase in government spending would steal resources away from private consumption and investment, and so the government spending would be offset by reductions in consumption and investment, and the increase in GDP from the government spending would be offset by the decrease in GDP from the reduced consumption and investment spending. But during an event like the Great Depression, there are a huge number if idle resources going unused. The additional government spending makes use of those idle resources, and so it is not offset by reductions anywhere else. In fact, the idea is that by employing those idle resources, the government spending spurs on more consumer spending and the added confidence in the economy spurs on more investment spending, so that the moderate amount of government spending can actually result in a large increase in total GDP, re-inflating the economy to support the wages and prices stuck in place and ending the paradox of thrift. Within a few short decades, Keynes had convinced the economics profession, and economists the world over successfully convinced just about every government in the world to try out this new-fangled Keynesian economics. And with FDR as our guide, it really seemed to be working.

Practice Questions

1. The Pagong economy is in a deep recession, with a $10 billion shortfall in GDP causing an unemployment rate of 20%! Many people are falling on desperate times, without enough money even for the basic necessities. For this reason, most will spend any additional money they earn. Economists estimate the marginal propensity to consume is 90%.

Based on the Keynesian framework, how much additional government spending would restore this economy to full employment?

Reveal the Answer

In economics, we throw around a lot of terminology that often boils down to something simpler. Here, the question wants to know how much additional spending will be needed to result in a $10 billion increase in GDP after it multiplied by the expenditure multiplier.

Step One - Find the Expenditure Multiplier

The MPC is 0.90, or 90%. Plugging that into the equation for the expenditure multiplier we get:

1 / (1 - 0.90) = 10

The expenditure multiplier is 10.

Step Two - Find the Additional Spending Needed

We want to find the additional spending, X, which when multiplied by 10, results in $10 billion.

X * 10 = $10 billion

X = $10 billion / 10

X = $1 billion

If the government spends an additional $1 billion, GDP will rise by $10 billion, reversing the shortfall in GDP and returning the economy to full employment.

2. The Pagong economy is in a deep recession, with a $10 billion shortfall in GDP causing an unemployment rate of 20%! Many people are falling on desperate times, without enough money even for the basic necessities. For this reason, most will spend any additional money they earn. Economists estimate the marginal propensity to consume is 90%.

Based on the Keynesian framework, how much should the government cut taxes to restore this economy to full employment?

Reveal the Answer

Wait, how is this not the same question!?

When the government spends $1 billion, with no offsets elsewhere, they have increased total spending in the economy by $1 billion, which is then multiplied by 10 (the expenditure multiplier) to a final impact of $10 billion.

But if they cut taxes by $1 billion, then people find themselves collectively with $1 billion more in their paychecks. We know from the MPC that they will only spend 90% of this, and so consumption spending goes up by only $900 million. This increase in total spending of $900 million is what we multiply by 10, leaving us with a final impact of $9 billion on the economy. We are still $1 billion short from reaching full employment.

To get consumers to spend an additional $1 billion, we need to give them a tax cut of:

$1 billion / 0.90 = $1.111 billion

So, the government needs to cut taxes by a total of $1.111 billion in order to instigate $1 billion in additional spending, and result in a $10 billion increase in GDP.

Note: Keynesians argue that government spending is more effective than tax cuts when trying to stimulate the economy.

Quick Quiz

Now is the time to test yourself on these concepts! This quick quiz is a great way to see what has clicked and what needs more attention. It is also a good time to reach out to your instructor with questions.

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Deeper Thoughts and Extra Practice

Dr. Goegan Explains...

Example Question
GDP for a small country was $295 billion last year. Economists believe that if healthy, this economy should grow by 4.9% this year. However, the country has been struck by a recession, and GDP this year is expected to be $268.8 billion. Empirical estimates suggest that the marginal propensity to consume in this country is 71.3%.

It's 3:00 AM and the president of this country calls you in a panic. "Please! My country needs you! We are going to do some fiscal policy, but we don't know how much to spend. You took Dr. Goegan's incredible course on Macroeconomics, so please, tell us, how much additional government spending will restore our economy to the level we expected to be at?"

You say, "Easy. Restoring your economy will cost you one free vacation for me plus $_________ billion."

What number fills in the blank, rounded to two decimal places?

Video Solution

Dr. Goegan Explains...

Example Question
Use the Quantity Theory of Money: M ⋅ V = P ⋅ Y

Concern about the economy has turned to panic, and bank runs have led to a 35.8% decrease in the money supply. The velocity of money has remained stable, but prices and wages seem to be sticky. They have only fallen by 8%.

Recessions are typically measured by the decline in real GDP (aka Output). What will be the percentage decline in output for this economy?

Put your answer in percentage form (e.g. 30.57 not 0.3057) and then round to two decimal places.

Video Solution

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