What Is The Keynesian Multiplier? - Investopedia

A multiplier is a factor in economics that proportionally augments or increases other related variables when applied. Multipliers are commonly used in macroeconomics, the study of the economy as a whole. The Keynesian multiplier demonstrates that the economy will flourish as the government increases spending.

Key Takeaways

• A Keynesian multiplier demonstrates that the economy will flourish as the government increases spending.
• According to the theory, the net gain is greater than the dollar amount spent.
• Marginal propensity to consume is a component of Keynesian macroeconomic theory that suggests that a boost in government spending will increase consumer spending. 

What Is the Keynesian Multiplier?

The British economist John Maynard Keynes formally introduced the concept of the multiplier in his "The General Theory of Employment, Interest, and Money" in 1936.

Keynes cited a lack of aggregate demand during the Great Depression and argued that government spending and fiscal stimulus could create a “multiplier effect." Any form of government spending could lead to cycles of economic prosperity and increased employment, raising gross domestic product (GDP) to levels higher than the cost.

Aggregate Demand and Consumption

Y=C+I+G

Where:

• Y=Aggregate demand 
• C=Consumer demand
• I=Investment demand
• G=Government demand

Keynes also introduced the concept of the consumption function:

C=mY

Where:

• m= the marginal propensity to consume (MPC) with m<1.
• Assume it is estimated at .75.

As consumers earn additional income, they spend 75% and save 25%. Investment demand was primarily determined by entrepreneurial spirits, interest rates, and current business conditions, while government demand was determined by the fiscal decisions made by the government.

In this framework, aggregate demand is expressed as:

• Y=C+I+G=mY+I+G

Solving this expression for Y results in:

Y=(I+G)/(1-m)

Where the term 1/(1-m) is the Keynesian income “multiplier.” With m=.75, the multiplier is 

1/(1-.75)=4

If Y falls due to a problem with Investment spending, the government can increase aggregate demand by increasing G.

If m=.75, then the multiplier is 4, indicating a 1-dollar increase in G. All other things being equal will result in an increase in income of 4 dollars in Y.

Keynesian Multiplier Example

Assume a $100 million government construction project pays $50 million in pure labor costs. The workers take that $50 million and, minus the average saving rate, spend it at various businesses. These businesses now have more money to hire new employees to make more products, leading to another round of spending. One dollar of government spending will generate more than a dollar in economic growth. This idea was at the core of the New Deal.

The core of President Roosevelt's New Deal is based on the theory of the Keynesian multiplier.

Keynesians wanted to tax savings to encourage people to spend more. The Keynesian model, developed by British economist John Maynard Keynes, arbitrarily separated private savings and investment into two separate functions, showing the savings as a drain on the economy.

What Is a Common Criticism of the Keynesian Multiplier?

Milton Friedman argued that the Keynesian multiplier was incorrectly formulated and fundamentally flawed. The theory ignores how governments finance spending by taxation or debt issues. Raising taxes takes the same or more out of the economy as saving, while raising funds by bonds causes the government to go into debt. The growth of debt becomes a powerful incentive for the government to raise taxes or inflate the currency to pay it off, thus lowering the purchasing power of each dollar that workers earn.

What Is the Marginal Propensity to Consume?

In Keynesian macroeconomic theory, the marginal propensity to consume is a variable in showing the multiplier effect of economic stimulus spending. It suggests that a boost in government spending will increase consumer spending. 

What Is Keynesian Economics?

The basic premise of Keynesian Economics relies on the argument that government intervention can stabilize the economy.

The Bottom Line

Keynesian economics assumes that government intervention can help stabilize the economy. The Keynesian multiplier demonstrates that the economy flourishes as the government increases spending and the net gain is greater than the dollar amount spent. Critics argue that the multiplier ignores how governments finance spending by taxation or debt issues.