According to Keynes and other economists linked with his views, any new spending (e.g., on building a road or a factory) generates several times as much revenue as the expenditure itself. This is because those who are paid to build the road or factory will spend more of what they receive; their expenditures will thus become income for others, who will in their turn spend most of what they receive. Every new act of investment, then, will have a stimulating effect on the collective income. This relationship is known as the investment multiplier.
While economic investments cannot produce cyclical movements in the economy, it can provide a positive nudge in the right direction. Keynes also theorized that consumer demand plays a critical role in economic recoveries. Increased demand for goods requires an increase in production capacity. For example, after everyone wanted a car, massive manufacturing plants had to be constructed to build them. This relationship, known as the accelerator, implies that an increase in national income will stimulate investment.
The multiplier and accelerator in combination are thought to cause strong cyclical movements. When an increase in investment occurs, it raises income to a degree that depends on the value of the multiplier. That increase in income may, in turn, induce a further increase in investment. The new investment will once again spark the multiplier process, producing additional income and investment. According to Keynes (and his adherents), the interaction might continue until a point is reached at which the resources of labor and capital are fully utilized.
At that point, there can be no increase in employment, which means that there will be no associated increase in consumer demand. The result of this is that the operation of the accelerator halts. That halt in demand causes new investment to decline and workers to be laid off. At that point, the zenith of the business cycle has been reached, and the downtrend begins.
There has been much dialog lately about “reaching full employment.” This conversation starts again every time new unemployment figures are released. The importance of these numbers is due to the inferences that we can draw from the theoretical position of Keynes: when full employment is reached, the economy is indeed booming. The other side of that same coin is that the boom has likely reached its peak, and a downturn is looming in the near future. Of course, Keynesian economics is not the only plausible explanation of cyclical fluctuations in the economy.
Political theories are frequently cited at the current midpoint of the Trump Administration. Tax cuts are hailed by the administration as a huge engine of economic growth. Opponents of the administration’s policies believe that “tough negotiations” with China will lead to an international trade war that will sink the economy. The precise impact of these elements and countless others can only be known with time.
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