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Frasier Understands The Multiplier Concept…

June 8th, 2009 · 21 Comments
Econ 101 · Macroeconomics · Policy

We’ve been hearing a lot lately about how government spending is supposedly going to get us out of a recession. I’ll leave the value judgments for the end and start with the reasoning. The reason that spending is attractive is because there is a theoretical multiplier effect on Gross Domestic Product (you can just think of this as a country’s output). The multiplier works as follows:

  • The government spends $1 on some sort of project. This $1 goes to some combination of individual workers, companies doing the work, etc.
  • The workers and companies take this $1 and turn around and spend some of it, let’s say 50 cents. The 50 cents spent then goes to the providers of the goods and services that it was spent on.
  • These providers of goods and services spend some of the 50 cents that they got, let’s say 25 cents.
  • And so on…

In the above example, the government spent $1, but total output (or income) went up by $1.75. It seems like there is some leverage to be had with government spending. (The same theory applies to a decrease in taxes as well, since a tax cut puts money into the hands of consumers who then spend at least some of it, thus starting a similar cycle.)

Apparently the characters on Frasier (my repertoire of bad/old TV watching is clearly expanding) understand this concept:

Niles: “By hiring a plumber that plumber can now afford, say, a Dolly Parton album. Ms. Parton can then finance a national tour, which will of course come to Seattle, allowing some local promoter to make enough money to send his cross-dressing teenage son to us for $150 an hour therapy.”

Frasier: “To the circle of life.”

I would say “to the theoretical stimulating of aggregate demand,” but whatever.

In order to present you with full information, I acknowledge that the jury is still out on how effective the multiplier concept is in practice. Greg Mankiw presents a view that government spending is too easy an answer, and Robert Barro says that government spending is no free lunch, though it does come with a nice side of voodoo economics (which is apparently just a disparaging term for supply-side economics). The second article is a bit, er, dense, but Mankiw’s article is a pretty easy read. The main points:

  • The multiplier on spending is likely smaller than people would like to think it is. Barro even argues that the multiplier could be less than 1- i.e. that a goverment spend of an extra $1 could crowd out some other consumption and investment and therefore not add a full $1 to GDP.
  • GDP increases aren’t necessarily beneficial if the increased output is on projects that are not socially valuable. (I particularly like the “You can pay someone $100 to dig a hole and then pay someone else $100 to fill it up” example. The point is that you’ve increased GDP by $200, but have you really created any value? As much as I like watching dirt being moved around, and paint dry for that that matter, I would argue that the answer is no.)
  • The government should think harder about how it’s going to pay for all this spending, since it’s going to have to do so eventually. (econgirl’s note: In this case, it’s worth considering that the multiplier effect could work in reverse too. Thought exercise- what might happen to GDP as a result of a $1 decrease in government spending?)
  • There might be a larger multiplier on tax cuts than previously thought. (econgirl’s note: tax cuts also don’t result in the government having to know or decide what projects are socially beneficial, since the market takes care of this, at least to a degree.)

All I will say for now is that at least the current stimulus plan will give economists some new data to play with.

Tags: Econ 101 · Macroeconomics · Policy

21 responses so far ↓

  • 1 Pablo // Jun 10, 2009 at 10:44 pm

    So, apparently economists are not so sure anymore whether government spending is a good stimulant for the economy? The way Macroeconomics courses were taught to me almost felt as if those theories were written in stone. The curves were pretty clear: Move AD to the write by increasing Government expenditures, and now you have an AD curve that meets the Aggregate supply curve at a higher output level…

    Now, aren’t the governments in Latin America or other less industrialized nations required to cut their spending in order to get a loan from the IMF or the World Bank? So when Cash-strapped governments recur to such lending institutions in order to fix their local markets, are they being asked to reduce their spending and therefore the Aggregate Demand?

    In short, it seems like Washington can afford to increase spending in a recession, but the “Washington Consensus” will not allow emerging markets to do so… Am I the only one noticing the contradiction here?

    ps: as I kept writing I realized that this whole post was lacking a concrete message, criticism, or comment, and instead turned out to be a written vent of my frustration with the Econ field…

  • 2 econgirl // Jun 11, 2009 at 8:00 pm

    I think your frustration is warranted, actually. Let me address a few points:

    1. You are exactly right in that economics textbooks are not good at making it clear that theories are, well, exactly that. To be fair, the theoretical models you see in current textbooks are those that have stood the test of time as new data becomes available, but not all texts give a clear picture of how much (or how little) empirical support there is for the theoretical models presented. They are also often not good at making clear what assumptions are necessary in order for a model to be applicable. People seem to like to complain that a model is “wrong” when in reality it is just being applied inappropriately.

    2. The main disagreement among economists is how large the multiplier effect on spending is, not whether spending stimulates the economy in the first place. Technically, however, the multiplier could be zero if the government spending crowds out private consumption and investment. (See http://www.economistsdoitwithmodels.com/2008/06/18/a-primer-on-ricardian-equivalence-or-why-you-should-put-your-tax-rebate-in-a-savings-account/ for an explanation of why.) In your terms, there is disagreement over how much aggregate demand moves in response to an increase in government spending. It could be that different economies respond differently to changes in spending, which would explain the contradiction that you mention.

    3. There is a difference between aggregate supply in the short run versus the long run. The situation you describe regarding the increase in output is a short run condition. In the long run output will go (more or less) back to normal as prices adjust. But then again, it’s just a theory. 🙂

  • 3 Christopher Scott // Jun 12, 2009 at 1:28 am

    Hey!

    First of all, I highly recommend checking out Paul Krugman’s NY Times blog, he delves highly into the issue of crowding out. He has a great post here

    http://krugman.blogs.nytimes.com/2009/05/02/liquidity-preference-loanable-funds-and-niall-ferguson-wonkish/

    Basically what he is saying is that people have been shocked into saving way more than usual, and businesses in anticipation of a downturn have cut off private investment because they doubt the returns they could get. What this results in is an equilibrium interest rate that should be less than zero (negative, but interest rates cannot go below zero, but that did happen with treasuries very briefly at one point), which means there is excess savings than what should be even at a zero interest rate (aka S does not equal I). Therefore, while normally an increase in government spending would crowd out private investment and raise interest rates, it will not in this case because there is just too much savings and not enough private investment to soak up the savings. Basically, government spending cannot crowd out private investment, because there is little private investment. We are in a classical Liquidity trap!

    I highly recommend checking out his post because it has models (I love doing models) to explain it a little better. So, since Government spending will not crowd out private investment (since we have a lack of it) maybe the multiplier will have a greater effect than normal times (since these are abnormal times)

  • 4 Christopher Scott // Jun 12, 2009 at 1:30 am

    Also, first time poster and reader of the blog, I LOVE IT and the humorous title. I’m a recent W&M graduate with a double major in Accounting and Economics, and after months of searching I was finally able to find a job!!! Talk about green shots! (No I do not mean Absinthe)

  • 5 ctc // Jun 12, 2009 at 1:38 am

    Correct me if I’m wrong……

    But fiscal stimulus, be it tax cut or increase in government spending, does not solve the underlying issue……

    While fiscal stimulus does fill the AD hole….
    That does not solve issues like not being able to compete with countries like China. Where our export based economy has now become exporting debt rather than goods. Manufacturing is key. And what do we manufacture and export that China does not manufacture and export a great deal cheaper than we do?

    Sorry I’m a bit typsy at the moment.

    Clint

  • 6 Dan L // Jun 12, 2009 at 4:00 pm

    econgirl: “The main disagreement among economists is how large the multiplier effect on spending is, not whether spending stimulates the economy in the first place. Technically, however, the multiplier could be zero…”

    I would contend that a multiplier of zero does not qualify as “stimulating the economy.”

    —————————————–

    The problem with introductory economics is that it oversells its usefulness. Intro economics is mostly useful for the further study of economics, just as intro physics is mostly useful for the further study of physics. The difference is that in Physics 101, when there’s a problem in which a frictionless pendulum continues to swing in perpetuity, everyone knows that this doesn’t happen in the real world. But in Econ 101, when there’s a problem that says that government policy A produces result B, students erroneously think that they’ve learned a useful lesson with applications to the real world. They have not.

  • 7 Pablo // Jun 12, 2009 at 5:13 pm

    That comparison between econ and physics pretty much summarizes the weaknesses of Economics and most social sciences. Trying to explain human behavior (the main goal of social sciences) can be tricky to say the least. Most of these social scientists believe they have the answers for pretty much every issue out there. To me they are just masters of the trial and error method…

    Tip: don’t you ever question the scientific side of pshychology as you will immediately be diagnosed with a new type of illness or anxiety…

  • 8 Krzysztof Wiszniewski // Jun 12, 2009 at 6:58 pm

    I see two major pitfalls to adress in the economic stimulus question, that have led me to be skeptical of its beneficial effect:

    One is the question of financing the stimulus: it can be done through a burden on the budget, leaving the question of how the additional cost is to be financed (which may result in the government eventually withdrawing more money from the economy than it injected) or through tampering with the money supply – we can probably agree that this is a bad idea.

    The other, brought up by Christopher Scott, is the present increased propensity to save. If the multiplier effect is to be observed, we will require households to actually spend the extra income received through the economic stimulus. It is conceivable that, at present, government investment will not greatly stimulate demand, leaving the way open to an over-supply problem.

    I see a heated debate raging over this very issue here in Poland and – despite once being a disciple of Keynes – I tend to side with the government, who are wary to adopt this policy.

  • 9 Christopher Scott // Jun 13, 2009 at 11:22 am

    The previous poster does bring up a good point, that because of the higher propensity to save, people will most likely save their income, having a diminishing effect on any increase in incomes a person may experience, diminishing the multiplier.

    However, Consumer spending has dropped off by over a trillion dollars. I think I remember it being 1.4 trillion. So I think it is a good thing that the government is stepping in and trying to fill the hole left by the drop off in consumer and investment spending.

    Also to note, because of the stimulus bill, America is now spending the largest percentage of GDP on scientific research since the Space Race. The scientific research done during those years have clearly paid dividends, providing us with many incredible inventions that have spurred incredible growth.

    Also to note, for years (I think the 1950’s) American Govt. spending accounting for 7% of GDP, but recently has been around 4% .

  • 10 Ahren Lippman // Jun 13, 2009 at 9:11 pm

    Great comments.

    The real question isn’t weather government spending is the correct action NOW, or weather it will crowd out non-existant private investment. I mean peak credit spreads made the great depression look like the 2000 recession.

    It’s weather the financing gap created through the trillion of excess debt will crowd out private investment for generations to come. Would anyone like to say it won’t?

    Clearly this was one way to fix the problem NOW, and it’s hard to see near term negatives with the plan. Hopefully we’ll see a full year GDP over 2% in our life times again. Depending on your current age, (and if you can read and use the internet, this means you) your chances aren’t great. I’m holding out for my 6mo. old son though.

  • 11 Rev. Pfloyd // Jun 14, 2009 at 10:09 am

    If I walked away with anything from economics classes it seems to be a simple formula:

    Consumer savings = good credit
    Federal Reserve stimulus = bad credit

    Not that I want to get too crazy with Austrian Business Cycle Theory but it seems to me when people are saving their own money, economies seem to be more stable and when we’re creating “easy money” economies get crazy.

    I like the idea of a tax cut creating more of a multiplier (because dollars aren’t getting eroded away by bureaucracy and normative decisions) than government spending (which is full of money erosion, normative decisions, and other forms of inefficiency). Whether it actually *does* create more of a multiplier will require a lot more research but I think the pooh-poohing of Supply-Side Economics in most economics circles means that sort of consideration might take a back seat. I think the time has come to revisit it, and analyze it fully.

    Of course, given our spending situation in a few years vis-a-vis social security, medicare, and medicaid tax cuts might be low on our priority scale.

  • 12 Christopher Scott // Jun 14, 2009 at 10:29 am

    Tax cuts were tried last year. They had no stimulative effect on the economy, because people used the money only to pay down debt or saved the money, which basically means we nationalized personal debt. See Irving Fischer’s theory of Debt Deflation to see why that is a bad thing…

  • 13 Rev. Pfloyd // Jun 14, 2009 at 12:37 pm

    Well I worry that we keep trying to find a panacea for our economic woes in government spending but I feel we are just perpetuating an already bad habit. Artificial prosperity is what got us here in the first place, is more of the same really the fix we all hope it will be?

    Honestly, I think people *should* be paying down debt; up until this year we were at a negative savings rate and so to keep the economy growing the Fed had to loosen the credit on their end to compensate. So the economy kept expanding and people kept consuming, instead of allowing the price system to stabilize consumer and corporate behavior.

    Now, I’m in full understanding that we can’t really just sit around with our thumbs planted in our backsides–especially given the amount of debt people have shouldered in the last few years–but this just seems like a never-ending spiral. Is this economic downturn the correction we long needed but kept delaying? And did delaying it put us into a situation where it is far worse now than it would have been if we had allowed an earlier correction? And lastly, is punishing the people who saved their money in order to help the people who didn’t really a good policy to keep sustaining?

    Those are my questions.

  • 14 jc // Jul 21, 2009 at 7:16 pm

    A college professor of mine had this on his door.

    We may not have answered all of our questions, or solved all of our problems; but we are now confused on a much higher level.

  • 15 econgirl // Jul 22, 2009 at 12:17 am

    Love it.

  • 16 Rev. Pfloyd // Jul 22, 2009 at 8:37 am

    Amen.

  • 17 Kurt Streich // Apr 5, 2010 at 8:04 pm

    I’m in full agreement that it seems amount of government spending accumulating into the national debt seems like a never-ending spiral. It needs to be dealt with. But at this during these recessionary times, the government needs to intervene with an expansionary fiscal policy (which will hopefully entail the multiplier effect). Hopefully, we will see growth after this and be able to work on the debt in the more prosperous future.

  • 18 Rev. Pfloyd // Apr 5, 2010 at 10:41 pm

    If we’re looking at trends from the past 50 years or so, I would contend that no politician has ever attempted to pay down the debt during prosperous times. It would be political suicide.

    And, hence, that’s the problem with all of this.

  • 19 Kurt Streich // Apr 13, 2010 at 10:33 am

    Dear Rev. Pfloyd (I hope I’m pronouncing that correctly),
    don’t you remember Bill Clinton? Before president Bush took office and gave tax cuts to the wealthy, we had a substantial surplus that was in fact paying down the debt. This graph shows that:
    http://yellowroad.wallstreetexaminer.com/blogs/files/2008/06/inflation.gif

    As for the future, I do feel that once prosperous times come our way again, spending will once again decrease. For, once our economy is set at full employment on the classical range, it does not make sense to increase spending or have an expansionary fiscal policy, because that will only lead to greater inflation, without any substantial increase in jobs. I think that spending will decrease at a time such as this, which will hopefully be able to be favorable politically at the time.

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