The Multiplier and Instability in the Economy – The Keynesian Perspective

John Maynard Keynes, a British economist, is often viewed as the father of modern macroeconomics.  In 1936 he published the ‘General Theory of Employment, Interest and Money‘ challenging the then prevailing Classical view of the macroeconomy and attempting to explain the instability in the economy exposed by the great depression of the 1930’s, the cycles of recessions and expansions, and offering policy prescriptions to minimize their harmful effects.

The Keynesian theory contends that the macroeconomy is not self correcting as previously thought by Classical economists but inherently unstable.  Full employment is not a guarantee, any deviation from it tend to be amplified and inflexibility in markets can prevent the economy from returning to full employment.

Keynesian key arguments:

  • The Classical theory that ‘Supply created its own demand’ (Say’s law) is not supported by events such as the Great Depression and aggregate demand is not always automatically high enough to provide firms with an incentive to hire enough workers to reach full employment.
  • The macroeconomy may adjust only slowly to shifts in aggregate demand because of sticky wages and prices, which are wages and prices that do not respond to decreases or increases in demand.
  • Any change in spending leads to a greater change in output, which means that the fluctuations of the business cycle are wide by nature.

Supply does not necessarily create its own demand

The first building block of the Keynesian diagnosis is that recessions occur when the level of household and business sector demand for goods and services is less than what is produced when labor is fully employed. In other words, the intersection of aggregate supply and aggregate demand occurs at a level of output less than the level of GDP consistent with full employment. Suppose the stock market crashes, as occurred in 1929. Or, suppose the housing market collapses, as occurred in 2008. In either case, household wealth will decline, and consumption expenditure will follow. Suppose businesses see that consumer spending is falling. That will reduce expectations of the profitability of investment, so businesses will decrease investment expenditure.

This seemed to be the case during the Great Depression, since the physical capacity of the economy to supply goods did not alter much. No flood or earthquake or other natural disaster ruined factories in 1929 or 1930. No outbreak of disease decimated the ranks of workers. No key input price, like the price of oil, soared on world markets. The U.S. economy in 1933 had just about the same factories, workers, and state of technology as it had had four years earlier in 1929—and yet the economy had shrunk dramatically. This also seems to be what happened in 2008.

As Keynes recognized, the events of the Depression contradicted Say’s law that “supply creates its own demand.” Although production capacity existed, the markets were not able to sell their products. As a result, real GDP was less than potential or full employment GDP.

The Expenditure Multiplier

A key reason behind the instability in the economy is the expenditure multiplier, the idea that not only does spending affect the equilibrium level of GDP, but that spending is powerful. More precisely, it means that a change in spending causes a more than proportionate change in GDP.

Initial Change in Spending x Expenditure Multiplier = Final Change in GDP

The reason for the expenditure multiplier is that one person’s spending becomes another person’s income, which leads to additional spending and additional income, and so forth, so that the cumulative impact on GDP is larger than the initial increase in spending.  The size of the multiplier effect depends on the spending patterns in the economy, more specifically how much our spending is likely to change as income change or our Marginal Propensity to Consume.  The greater the MPC, the greater the multiplier effect.

Expenditure Multiplier = M = 1/ (1- Marginal Propensity to Consume)

 

  

 

 

 

 

 

 

 

 

 

 

 

 

The multiplier occurs with any autonomous increase in spending. Additionally, the multiplier operates in a negative as well as a positive direction. Thus, when investment spending collapsed during the Great Depression, it caused a much larger decrease in real GDP. The size of the multiplier is critical and was a key element in recent discussions of the effectiveness of the Obama administration’s fiscal stimulus package, officially titled the American Recovery and Reinvestment Act of 2009.

Wage and Price Stickiness

Keynes also pointed out that although AD fluctuated, prices and wages did not immediately respond as economists often expected. Instead, prices and wages are “sticky,” making it difficult to restore the economy to full employment and potential GDP. Keynes emphasized one particular reason why wages were sticky: the coordination argument. This argument points out that, even if most people would be willing—at least hypothetically—to see a decline in their own wages in bad economic times as long as everyone else also experienced such a decline, a market-oriented economy has no obvious way to implement a plan of coordinated wage reductions. Unemployment proposed a number of reasons why wages might be sticky downward, most of which center on the argument that businesses avoid wage cuts because they may in one way or another depress morale and hurt the productivity of the existing workers.

Some modern economists have argued in a Keynesian spirit that, along with wages, other prices may be sticky, too. Many firms do not change their prices every day or even every month. When a firm considers changing prices, it must consider two sets of costs. First, changing prices uses company resources: managers must analyze the competition and market demand and decide what the new prices will be, sales materials must be updated, billing records will change, and product labels and price labels must be redone. Second, frequent price changes may leave customers confused or angry—especially if they find out that a product now costs more than expected. These costs of changing prices are called menu costs—like the costs of printing up a new set of menus with different prices in a restaurant. Prices do respond to forces of supply and demand, but from a macroeconomic perspective, the process of changing all prices throughout the economy takes time.

Because wages and prices tend to be sticky, especially downward, and adjust slowly and not completely, recessions can be deep and long lasting.

WHY IS THE PACE OF WAGE ADJUSTMENTS SLOW?

The recovery after the Great Recession in the United States has been slow, with wages stagnant, if not declining. In fact, many low-wage workers at McDonalds, Dominos, and Walmart have threatened to strike for higher wages. Their plight is part of a larger trend in job growth and pay in the post–recession recovery.

Jobs Lost/Gained in the Recession/Recovery

The chart on the left shows that the majority of jobs lost during the recession were from people working mid-wage occupations (60%). The chart on the right shows that the majority of jobs gained during the recovery were from people working lower-wage occupations (58%).

Data in the aftermath of the Great Recession suggests that jobs lost were in mid-wage occupations, while jobs gained were in low-wage occupations.

The National Employment Law Project compiled data from the Bureau of Labor Statistics and found that, during the Great Recession, 60% of job losses were in medium-wage occupations. Most of them were replaced during the recovery period with lower-wage jobs in the service, retail, and food industries. This data is illustrated in the above graph.

Wages in the service, retail, and food industries are at or near minimum wage and tend to be both downwardly and upwardly “sticky.” Wages are downwardly sticky due to minimum wage laws; they may be upwardly sticky if insufficient competition in low-skilled labor markets enables employers to avoid raising wages that would reduce their profits. At the same time, however, the Consumer Price Index increased 11% between 2007 and 2012, pushing real wages down.