It is accepted by most economists that initial increases in consumer
spending or other outlays tend to set in motion a reinforcing process which
supposedly strengthens the economic growth by a multiple of initial spending.
The Multiplier Explained
An example will illustrate how initial spending raises the overall output
by the multiple of this spending. Let us assume that out of an additional
dollar received, individuals spend 90 cents and save 10 cents. Also, let us
assume that consumers have increased their expenditures by $100 million. As a
result of this, retailers' revenue rises by $100 million. Retailers in
response to the increase in their income consume 90 percent of the $100
million. That is, they raise expenditures on goods and services by $90
million. The recipients of the $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 the 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 (10x$100
million) than it was before consumers had increased their initial expenditure
by $100 million.
Observe that the more that is being spent from additional income, the
greater the multiplier is and therefore the impact of the initial spending on
overall output is larger. For instance, if people change their habits and
spend 95 percent from 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.
The Key Role of Savings
Underlying all of this is the assumption that the less that is saved, the
larger is the impact of an increase in overall demand on overall output. But
is more saving bad for the economy as the Keynesian multiplier model implies?
As we shall see, it is an increase in saving and production, and not an
increase in consumption that leads to more economic activity.
Take, for instance, Bob the farmer who has produced twenty tomatoes and
consumes five tomatoes. What is left at his disposal is fifteen saved
tomatoes (real savings). With the help of the saved fifteen tomatoes Bob can
now secure various other goods.
For example, he secures one loaf of bread from John the baker by paying
for the loaf of bread with five tomatoes. Bob also buys a pair of shoes from
Paul the shoemaker by paying for the shoes with ten tomatoes. Note that real
savings at his disposal limits the amount of consumer goods that Bob can
secure for himself.
When Bob the farmer exercises his demand for one loaf of bread and one
pair of shoes he is transferring five tomatoes to John the baker and ten
tomatoes to Paul the shoemaker. Bob's saved tomatoes maintains and enhances
the life and well being of the baker and the shoemaker. Likewise, the saved
loaf of bread and the saved pair of shoes maintain the life and well being of
Bob the farmer. Note that it is saved final consumer goods which sustain the
baker, the farmer, and the shoemaker, that makes it possible to keep the flow
of production going.
Turning Savings into Production
Now, the owners of final consumer goods, rather than exchanging them for
other consumer goods, could decide to use them to secure better tools and
machinery. With better tools and machinery a greater output and a better
quality of consumer goods can be produced some time in the future. Note that
by exchanging a portion of their saved consumer goods for tools and
machinery, the owners of consumer goods are in fact transferring their real
savings to individuals that specialize in making these tools and machinery.
Real savings sustain these individuals whilst they are busy making these
tools and machinery.
Once these tools and machinery are built, this permits an increase in the
production of consumer goods. As the flow of production expands, this permits
more savings all other things being equal. This in turn permits a further
increase in the production of tools and machinery. This makes it possible to
lift further the production of consumer goods (i.e., raise the purchasing
power in the economy). So, contrary to popular thinking, more savings
actually expands and not contracts the production flow of consumer
goods.
Can the increase in the demand for consumer goods lead to an increase in
the overall output by the multiple of the increase in demand? To be able to
accommodate the increase in his demand for goods, the baker must have means
of payment (i.e., bread to pay for goods and services that he desires). We
have seen that the baker secures five tomatoes by paying for them with a loaf
of bread. Likewise the shoemaker supports his demand for ten tomatoes with a
pair of shoes. The tomato farmer supports his demand for bread and shoes with
his saved fifteen tomatoes.
More Production Leads to More Consumption
Whenever the supply of final goods increases, this permits an increase in
demand for goods. The baker’s increase in the production of bread permits him
to increase demand for other goods. In this sense, the increase in the
production of goods gives rise to demand for goods. People are engaged in production
in order to be able to exercise demand for goods to maintain their life and
well being. We have seen that what enables the expansion in the supply of
final consumer goods is the increase in capital goods or tools and machinery.
What in turn permits the increase in tools and machinery is real savings. We
can thus infer that the increase in consumption must be in line with the
increase in production.
From this we can also deduce that consumption doesn’t cause production to
increase by the multiple of the increase in consumption. The increase in
production is in accordance with what the pool of real savings permits and is
not constrained by consumers’ demand as such. Production cannot expand
without support from the pool of real savings.
Government and the Multiplier
Let us examine the effect of an increase in the government's demand on an
economy's overall output. In an economy which is comprised of a baker, a
shoemaker, and a tomato grower, another individual enters the scene. This
individual is an enforcer who is exercising his demand for goods by means of
force.
Can such demand give rise to more output as the popular thinking has it?
On the contrary, it will impoverish the producers. The baker, the shoemaker,
and the farmer will be forced to part with their product in an exchange for
nothing and this in turn will weaken the flow of production of final consumer
goods. Again, as one can see, not only does the increase in government
outlays not raise overall output by a positive multiple, but on the contrary
this leads to the weakening in the process of wealth generation in general.
According to Mises in Human Action, "… there is need to
emphasize the truism that a government can spend or invest only what it takes
away from its citizens and that its additional spending and investment
curtails the citizens' spending and investment to the full extent of its
quantity."
