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Assignment: Keynesian Formula & Multiplier

Keynesian Formula:

The Keynesian formula was developed by the British economist John Maynard Keynes. Keynes was an influential economist who was greatly influenced by the events of the Great Depression in the 1930s. He was a great influence upon government economic policy after the Second World War and was involved in the establishment of The World Bank and the International Monetary Fund at the Bretton Woods Conference in 1944. Keynes explained that the level of output and employment in the economy was determined by aggregate demand or effective demand. In a reversal of Say's Law, Keynes in essence argued that "man creates his own supply," up to the limit set by full employment. Monetarists have always been critical of Keynes' work.

Composition of the Keynesian Formula

In scientific notation, the Keynesian Formula consists of the following make-up:

C + I + G + X − M = Y (GDP) which means:

Consumption + Investment + Government Spending + Exports − Imports = Gross Domestic Product

Consumption: In Keynesian economics aggregate consumption is total personal consumption expenditure, i.e., the purchase of currently produced goods and services out of income, out of savings (net worth), or from borrowed funds. It refers to that part of disposable income (income after taxes paid and payments received) that does not go to saving.

Investment: Investment is a term with several closely-related meanings in business management, finance and economics, related to saving or deferring consumption. An asset is usually purchased, or equivalently a deposit is made in a bank, in hopes of getting a future return or interest from it. Literally, the word means the "action of putting something in to somewhere else".

Government Spending: Government spending or government expenditure consists of government purchases, which can be financed by seignior age, taxes, or government borrowing. It is considered to be one of the major components of gross domestic product.

- John Maynard Keynes was one of the first economists to advocate government deficit spending as part of a fiscal policy to cure an economic contraction. In Keynesian economics, increased government spending is thought to raise aggregate demand and increase consumption.

Exports: In economics, an export is any good or commodity, transported from one country to another country in a legitimate fashion, typically for use in trade. Export is an important part of international trade. Its counterpart is import.

Export goods or services are provided to foreign consumers by domestic producers. Export of commercial quantities of goods normally requires involvement of the Customs authorities in both the country of export and the country of import.

Imports: In economics, an import is any good or commodity, brought into one country from another country in a legitimate fashion, typically for use in trade. Import goods or services are provided to domestic consumers by foreign producers. Import of commercial quantities of goods normally requires involvement of the Customs authorities in both the country of import and the country of export.

GDP: A common measurement of national income.

What is the Keynesian Multiplier?

The Keynesian multiplier was introduced by Richard Kahn in the 1930s. It showed that any government spending brought about cycles of spending that increased employment and prosperity regardless of the form of the spending. For example, a 100 crore rupees government project, whether to build a dam or dig and refill a giant hole, might pay 50 crore rupees in pure labor costs. The workers then take that 50 crore rupees and, minus the average saving rate, spend it at various businesses. These businesses now have more money to hire more people to make more products, leading to another round of spending for growth of the welfare state.

Taken further, if people didn't save anything, the economy would be an unstoppable engine running at full employment. Keynesians wanted to counteract saving by taxing savings to force people to spend more. The Keynesian model arbitrarily separated private savings and investment into two separate functions, showing the savings as a drain on the economy and thus making private investment look inferior to deficit spending. Unless someone holds his or her savings entirely in cash – and true hoarding like this is rare - it's invested either by the individual or by the bank holding the capital. Friedman, among others, showed that the Keynesian multiplier was both incorrectly formulated and fundamentally flawed.

One flaw is ignoring how governments finance spending: taxation or debt issues. Raising taxes takes the same or more out of the economy as saving; raising funds by bonds causes the government to go in 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 the workers are earning. Perhaps the biggest flaw is ignoring the fact that saving and investing have a multiplier effect at least equal to that of deficit spending, without the debt downside. In the end, it comes down to whether you trust private individuals to spend their own money wisely or whether you think government officials will do a better job.