Quiz 11: Fiscal Policy: the Keynesian View and the Historical Development of Macroeconomics
Total spending or aggregate demand determines the equilibrium rate of output in the Keynesian model. As per Keynesian model, equilibrium in an economy is achieved when total spending or aggregate demand in the economy equals the current output. Moreover, as per Keynesian views, equilibrium in an economy can be achieved at a level of output which can be less than the full employment level of output. According to Keynes, when total spending remains deficient that is less than the full employment output, high unemployment rate is experienced and output in the economy remains below its potential level resulting in weak economy. If total spending remains weak for long, economy also remain weak for same period and unemployment rates high. Same scenario was prevailing during the 1930s when due to pessimistic attitude of the consumer due to uncertainty about future total spending was at all time low and this has resulted in cut in production by businesses and job losses. As this situation has remained throughout the 1930s, total spending remained week persistently during 1930s resulting in high unemployment rate and weak economy. Therefore, as per Keynes, the Great Depression lasted so long and the unemployment rate remained so high throughout the 1930s because total spending during that period remained persistently deficient.
According to Keynesians, changes in total spending cause fluctuations in output. When total spending increases, sales of businesses also increases and their inventories decline and businesses are induced to increase their production resulting in larger output being produced in the economy. On the other hand, when total spending declines, sales of businesses also declines and their inventories rise prompting them to cut their production to reduce the buildup of inventories resulting in smaller output being produced in the economy. To maintain full employment capacity, aggregate demand or total spending must be maintained at a level that is consistent with the full employment capacity.
Multiplier Principle This principle states that an initial increase in spending expands the total income in the economy by a multiple of that initial increase in spending. The basic premise behind the multiplier principle is that the expenditure by one person becomes income of the other person which when spent further becomes income of another person and in this way initial spending going through a successive round of earning and spending increase the total income in the economy by a multiple of initial spending or expenditure. Size of multiplier is determined by the marginal propensity to consume that is part of the additional income that people decides to spend on consumption. Higher the marginal propensity of consume, larger would be the size of multiplier and smaller the marginal propensity of consume, smaller would be the size of multiplier. As stated above due to multiplier effect any increase or decrease in spending get magnified and thus bring much larger increase or decrease in total income. This kind of impact of the multiplier on total income makes the task of stabilizing the economy more difficult. For example, if economy is starting to heat up (price level is increasing) and authorities take step to reduce total spending in economy by some amount then this reduction in spending due to multiplier impact can lead to much larger reduction in spending and might push the economy towards recession. So, multiplier impact makes the task of stabilizing the economy difficult.