1Models of Output Determination

1. Keynes versus the Classicists

Almost every contemporary textbook includes a treatment of the Keynesian model. I will describe the Keynesian model throughout the first part of this unit, but then follow with a critique of the Keynesian theory and a discussion of the classical and Austrian school’s theory on the importance of saving and spending on capital goods in our economy.

2. The Keynesian Model

John Maynard Keynes was an economist who wrote his most important works, including his most famous oone, The General Theory of Employment, Interest and Money (1936) during the 1920s and 1930s. He was very influential during the Great Depression of the 1930s when many economists and politicians were looking for answers to solve the terrible output declines and accompanying high unemployment. His economic views led our government to pass the Employment Act of 1946, which established the Council of Economic Advisors and committed the federal government to intervene in the economy.

The classical economists, whose thoughts were wwidely accepted in Western economies before the 1920s, believed that economic downturns can best be solved by leaving the economy alone and letting private market forces correct the problems. A self-correcting mechanism (Adam Smith’s “invisible hand”) is in place, which aallows for only minimal government involvement in the economy.

With the economic problems getting worse during the 1930s, Marxian economic theory gaining more acceptance, and big businesses (and specifically their “robber baron” owners) beginning to be seen as the cause of all economic evil, people started to look towards the government for answers. Keynes’ theories provided precisely the fuel which socialist minded economists and philosophers of that time needed to propose government intervention as the solution to all economic problems.

According to Keynes, overproduction and underconsumption are always the main causes of any economic downturn. If businesses overproduce during one period of time, they experience surpluses and will need to cut back on their production during the next period. Cutbacks in production aare accompanied by layoffs and declining earnings.

Declining earnings mean even less spending during the next production period, so that businesses find themselves with even greater surpluses. This leads to a snowball effect which puts the economy eventually into an economic depression. Keynes stated that the only way to stop the ball from rolling is for the government to intervene by artificially creating demand and raising people’s earnings. This can be done by initiating public works or increasing welfare handouts or iincreasing general government spending.

The money the government uses to finance these expenditures can be obtained by running budget deficits. The government finances these deficits by either borrowing from the public (issuing Treasury bonds) or by printing money through its Federal Reserve System.

3. Consumption and the Multiplier

The Keynesian model is based on the belief that consumption demand drives the economy and that a shortfall in this demand causes recessions and depressions. If we can find ways to stimulate consumption, we will solve the problem. Keynes invented a concept called the marginal propensity to consume (MPC). The MPC indicates how much of any additional earnings people consume.

4. Savings, the Tax Multiplier and the Balanced Budget Multiplier

Keynes’s complement of the marginal propensity to consume is his marginal propensity to save (MPS). Savings is defined as income not consumed. Consequently, if a person receives additional income of $100 and of that he consumes $80, his saving from this same $100 is $20. The MPC in this case is .8 or 80% and the MPS is .2 or 20%. It is true in all instances that the MPC and the MPS add up to 1. Note also that MPS=1-MPC, so that the multiplier can be rewritten aas 1/MPS.

What is true for a government injection (say additional spending of $1000), must work in reverse for a government tax increase. When the government spends money, certain groups in our society receive additional money. When the government raises taxes on certain individuals, these people lose take home earnings. A multiplier effect works for taxes in reverse as well. However, Keynes argued that since people would have spent only a fraction of this money anyway (80% in the above example), the decrease in overall spending from a tax increase is not as large as the increase in overall spending from a government spending increase. The tax multiplier can mathematically be derived to equal the negative number of the regular spending multiplier minus 1. In the above example, the spending multiplier is 5 and therefore the tax multiplier is -4.

5. Critique of the Keynesian Model and the importance of Saving to Allow Spending on Capital Goods

There are some important flaws in the Keynesian model as described by the following reasoning based on theories heavily influenced by Austrian school and neo-classical and classical economists, such as George Reisman, Ludwig Von Mises, Ayn Rand, Adam Smith, David Ricardo, and Jean Baptiste Say.

The main flaw iis Keynes’s belief that wealth and production can be created and “multiplied” out of nothing, i.e. by artificially stimulating demand. Keynes held that as long as there is enough demand, supply will follow and unemployment will disappear. However, Keynes never considered where the funds for this demand really would come from. In the Keynesian model, if the government increases its spending. It can obtain the funds to do so from only two sources: 1. printing money, or, 2. borrowing from the public.

If it prints the money, the value of the money decreases by the same amount as the supply of the money increases. In terms of purchasing power, in the long run, therefore, there can be no additional real money and so there can be no additional real demand. It may be true that initially some people feel somewhat wealthier because they are the recipients of the additional government money. These people can indeed increase their spending relative to what it was before. However, as soon as inflation takes effect, there will be in all other parts of the economy groups of people harmed by the rising prices. In the long run (after the inflation takes effect), this group’s drop

in purchasing power and accompanying decrease in demand offsets the other groups’ increase in demand. In reality, because of the harmful effects of inflation, inefficiencies and malinvestments become prevalent in the economy, and the decrease in demand is likely to more than offset the initial increase in demand.

If the government borrows the funds from the public, a similar effect can be observed. Again, the beneficiaries of the government spending do experience an increase in their income. In this case it iis an increase in their real income, because there is no inflation. Consequently, they increase their real demand. However, the people lending their funds to the government experience a decrease in their availability of funds and demand fewer goods or lend less money to businesses. As they demand fewer goods, it offsets the increase in demand on the part of the government. As they lend less to businesses, investment spending decreases. In either case, no real increase in demand occurs.

The ttruth is that any creation of wealth, production and jobs must be initiated at the production side, not the demand side. Only when entrepreneurs and workers become more industrious and productive, is additional real purchasing power created. Additional real purchasing ppower equates to additional real demand. This important conclusion was first verbalized by a French economist, Jean Baptiste Say, who came up with what is now known as Say’s Law, which states that any supply creates its own demand.

To see Say’s Law in a different context, imagine an “economy” with absolutely no economic activity. There is no production, so there can be no purchasing power or demand. No government handout or other artificial stimulation of demand can change this situation and magically create demand if there is no production and no goods exist. Production must occur first and then, from the fruits of the laborers’ work and earnings, demand follows. Production creates wealth by combining labor with technology along with tthe earth’s abundant resources. If no money exists initially, the first goods can be bartered to create economic activity. Eventually, a medium of exchange (for example, gold or silver) can be produced to facilitate trade. Once a medium of exchange (money) exists, people can save their earnings and perhaps start their own business or invest in existing businesses, so that even more production can occur. Additional production creates additional jobs, which creates additional purchasing power and subsequent spending. The additional sspending provides businesses with more funds, which if reinvested, leads to still more production and increased purchasing power.

Consumer and business saving is essential to allow firms to add to production capacities and create additional wealth. When people save, it frees up funds which businesses can use (borrow) to purchase capital goods. Additional capital goods (beyond what is needed to replace worn out and obsolete machines), allows for greater productivity, which enables businesses to pay higher real wages and create greater purchasing power.

If people don’t save, i.e. if they spend all their earnings on consumption, there will eventually be no money left to purchase capital goods. All the money is spent on cars, food, microwave ovens, clothes, etc. If this happens, businesses (whose owners themselves are not saving to reinvest in the business either) will find themselves with fewer and fewer production capacity and eventually with significantly less production. Less production means fewer jobs, less purchasing power and real demand, and a regressing economy which eventually loses all capacity to produce.

It is ironic that Keynes prescribed increases in consumption, when the above shows that what really should be encouraged is greater saving to allow businesses to invest in capital goods to iincrease production. In the long run, as a result of this greater capacity to produce, can consumption increase. This consumption increase is made possible by the economy’s greater capacity to produce.