Why Keynes Was Wrong About Consumer Spending

As a result of the coronavirus pandemic, most experts are of the view that it is the role of the government and central bank to minimize the damage inflicted by the virus—and the policy response to it—on the economy.

The logic behind this reasoning is that increases in the demand for goods and services are the heart of economic growth. It is held that increases or decreases in demand are behind the rises and declines in the economy’s production of goods and services. It is also held that the overall economy’s output increases by a multiple of the increase in expenditure by government, consumers, or businesses.

An example will illustrate how an initial bout of spending raises the overall output by a multiple of this spending. Let us assume that of an additional dollar received individuals spend $0.9 and save $0.1. Let us also assume that consumers have increased their expenditure by $100 million. Because of this, retailers' revenue rises by $100 million. Retailers, in response to this increase in their income, also consume 90 percent of the $100 million, i.e., they raise their expenditure on goods and services by $90 million. The recipients of these $90 million in turn spend 90 percent of the $90 million, i.e., $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 that expenditure by one person becomes the income of another person). At each stage in the spending chain, people spend 90 percent of the additional income they receive. This process eventually ends, so it is held, with total output higher by $1 billion (10 x $100 million) than it was before consumers increased their initial expenditure by $100 million (the multiplier here is 10).

Observe that the more is being spent from additional income, the greater the multiplier is, and therefore the larger the impact of the initial spending on overall output is. For instance, if people change their habits and spend 95 percent of each dollar, the multiplier will become 20. Conversely, if they decide to spend only 80 percent and save 20 percent, then the multiplier will be 5. All this means that the less that is being saved, the larger will be the impact of an increase in overall demand on overall output.

The popularizer of the magical power of the multiplier, John Maynard Keynes, wrote,

If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coal mines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course by tendering for leases of the note-bearing territory), there need be no more unemployment and with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is.1

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