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Deficit Financing, Inflation, and Keynesian Economics

May 21, 2010

A few days ago I wrote about how nothing in this world is random.  Well, when you go to the store and prices continue to rise, college costs soar to new heights, and home prices bloat, none of that is random either.  There’s laws behind all of that.  There’s two main reasons behind inflation — the government spending printed money and the Federal Reserve with their system of fractional reserve banking and manipulation of interest rates, which creates a private cartel for the banking industry.

Before I studied economics I used to wonder why every year people asked their employers to give them a raise.  Why?  People will tell you that the cost of living increases every year.  But that only begs the question: why do costs go up every year?  Why does everything become more expensive?

It all has to do with the government and the banking industry screwing around with the supply of money and deficit spending.  Unfortunately after all is said and done, we the people are always getting the short end of the stick.

In short, our economic system can be summarized as followed:  Scientific technological advances bring down prices whereas our monetary and economic systems continue to erode our currency, destroying its purchasing power.  The two are in continual struggle.  In 1950 one man working and the wife staying home could provide for the entire family.  Now in 2010, both work, have no time for their kids, and STILL can’t pay all their bills, all while suffering under a mountain of debt.  How did this happen?  It’s our government following bad economic policy.

Now there’s intricate Keynesian arguments as to why economists think they can screw around with the money supply and bring about prosperity to us all.  I’ve read several of their textbooks and don’t buy into any of it.

Liberal news pundits and the New York Times make no sense to me when it comes to finance and fiscal policy.  I’m with them when it comes to civil liberties.  I too think the wars need to end and we need to bring the troops home.  I worry for college students getting buried in debts before they’re old enough to even know what they want to do with themselves.  But what I can’t ever understand is their fiscal policies.  They say that government spending can cure an economic recession.  I’d like to go on one of their shows and bring up the following point – I wonder how they’d respond.

Me: “So you advocate that government spending will cure our economic problems.  Ok.  Let’s assume I had a large-scale counterfeiting operating going on in my basement.  Say I was printing billions of dollars down there and spending the money in my community.  Now if I started all sorts of pet projects which were to my own benefit, and hired all kinds of people, and this brought about economic prosperity to my community by providing jobs and income, why would this be a bad thing?”

Them: “Well you would receive a benefit not available to everyone else when you spent the printed money.”

Me:  “Wait wait wait liberal news pundit.  Doesn’t this printed money put funds in people’s hands?  Wouldn’t the money multiplier get to rolling and then the funds circulate throughout the economy benefitting everyone?  Wouldn’t it be just like the government spending money and the magical helicopter dropping funds down on everyone, so they’d have funds to spend and rev up the economy?”

Them:  “You know people can’t be counterfeitting money.  That’s just silly.”

Me:  “Is it?  It’s not different from what Keynesian textbooks tell us brings prosperity.  The government is not some holy sinless entity, they’re just people too.  But instead of dodging the question, like you are, I’ll explain WHY this is bad.  What would happen is my community here in Missouri would benefit but others would simply experience inflation.  I’d spend printed money in local stores, who most likely import their goods from a whole network of providers in various locations, and whoever got the money further down the line would only experience increased costs yet receive no benefit.  The early receivers of the printed money get all the benefit.  My community would prosper but others would be impoverished.  It would be unfair.  And by the way, you all love to say how corrupt Washington is.  How we need to throw the whole lot of them out.  Why is giving them an open checkbook to spend printed money on whatever projects they want going to benefit us?”

Them:  “It will put money in people’s pockets.”

Me:  “Not necessarily.  That all depends on who gets the government contracts and projects.  In theory we COULD benefit from this situation, but we also could lose very big.  Also, who is this “people” you’re referring to?  “People’s pockets”.  There is only individuals.  Whoever receives the printed-money contracts get the benefit, everyone else necessarily loses and experiences increased costs.”

When I give this analogy, I’m not exaggerating at all.  This is the exact situation when it comes to the government spending printed money in the economy to stimulate things.  This is exactly what President Obama is doing, and the ones who are “stimulated” are whoever get the contracts.  As the new money diffuses into the economy, those further down the monetary line all lose out.  But I hope within this entry to explain what people like president Obama think and why they do what they do.

I don’t feel we benefit very much from government “stimulus” projects.  I think the contracts are awarded to all the politicians’ buddies, political favors, etc., and we just get stuck with inflation.  But in theory I admit we could possibly benefit.  It’d be near impossible to plan though.  There’s practically an infinite number of complex relationships between businesses, so knowing how those funds will flow once you get the process started, and who will get their hands on the money early, and who will get the short end of the stick, would be impossible to know.  If I was guess who would benefit though, I’d guess the politicians and their buddies, lobbyists, and campaign donors, who would be on the top priority list.

And I suppose that the money could land in just the right person’s hands, who then come into the capital he or she needs to get some business going, or invent some new technology, or whatever, and this new technology or production method brings down the costs of something I buy, making my existing money stretch further.  I think the likelihood of this happening is so low as to not even be worth considering.

There are proper places for the government.  They need to protect the environment.  They need to handle the electricity.  After all, could you imagine every company needing its own set of power lines to send us power?  We’d have power line poles everywhere and it’d be so ugly.  They need to fund the police and provide a limited means to the poor.  We need schools.

Even so, I just can’t understand Keynesian economics.  I read textbook after textbook and they never answer that simple question of counterfeitting I just brought up.  If this printed money brings about economic prosperity, counterfeitting shouldn’t be illegal, but praised.  Here’s an excerpt from one textbook talking about deficit spending:

“Suppose the president of the United States asks for your advice.  The economy he confronts is the recessionary one of Exhbit 3, and his goal is to bring the economy to equilibrium at full employment.  What do you tell him?

How about presidential persuasion?  You could advise the president to invite the economy’s most influential producers to a White House breakfast and there explain the importance of increasing aggregate expenditures.

It would be marvelous if all it took was a little presidential sweet talk to get producers to add another $80 billion to investment.  But even producers who voted twice for the president couldn’t justify a penny more investment when the economy is already in equilibrium at Y = $800 billion.  Where, then, do you find the $80 billion?

Enter Government

If nobody else will do it, government can.  How does government get into an $80 billion investment business?  It designs a public investment package that totals $80 billion.  In ten minutes the president can probably come up with projects that would completely close the recessionary gap.

There are always more superhighways to build, more public housing to construct, more pollution control facilities to finance, more space shots to make, more health care schemes to fund, and more defense to procure.  In fact, the least of his problems would seem to be finding suitable projects to absorb the $80 billion.

What about Congress?  Would it go along?  Members of Congress have been sensitive to voters’ concerns back home, and among their concerns in times of recession are jobs.

The government now becomes an integral part of the economy’s aggregate expenditures.  What was once AE2 is now AE2 = the $80 billion increase representing the government purchases of goods and services.

Suppose the president asks you the brief the White House staff on your $80 billion recommendation.  You prepare Exhibit 3, panels a and b, which shows the economy struggling along without the $80 billion of government spending on goods and services, and how the economy fares with the government spending.  They would see the difference immediately.”

So what do we do when a recession kicks in.  First we invite all the big corporations in and say, “Guys, you have all this money.  Just spend a little of it.  Invest in some new technology.  C’mon guys, have a little heart!  The economy’s at stake!”

Then the Fortune 500 CEOs cross their arms, shake their heads, and say, “Sorry Mr. President.  We can’t justify a penny more in spending.  It’d hurt our bottom line.”

Oh woe is us.  What can we do?  Is a recession inevitable?  Nah!  Who you kiddin’?  All it takes is 10 minutes of President Obama’s time to whip up some spending projects, throw some money at it all, and boom, problem solved!  I’m glad the economy is so easy to manage.  All we have to do is give the politicians an open-checkbook of $80 billion in spending, or whatever their Keynesian math models predict is needed to bring aggregate supply and demand in “equilibrium”, and they go to town.

How will they get the money?  Well, let’s increase taxes.  Uh oh, people don’t like taxes.  Well, they don’t understand the beauty of Keynesian economics.  *sarcasm* If they understood the money multiplier, the paradox of thrift, and monetary velocity, they’d be giving the government 80% of their paycheck without question.  I’ll attempt to explain all this.  First I need to explain aggregate supply and aggregate demand and their equilibrium, which is what all their policies strive for.  Then we’ll discuss the income multiplier, and the tax multiplier.  Based on these assumptions I’ll show you why they think government spending, such as making bombs and munitions, fixes economic problems.

In short, aggregate demand and aggregate supply are very similar concepts to supply and demand on the microeconomic scale.  I’m sure you all know the basics of supply and demand.  For example, if you flood a market with a product, the price drops as people no longer want it, and want to spend their money on other things instead.  Even if it was rare and expensive before, once the supply is made abundant its price falls.  Prices and money are our system to manage and allocate scarce resources.

Ok, so what is aggregate supply and aggregate demand?  Its an abstract attempt to apply the same concept to the economy at large.   The aggregate supply represents the total quantity of goods and services that firms in the economy are willing to supply at different prices.  Its curve relates the “price level” to “real GDP”.  The aggregate demand curve  represents the total quantity of goods and services demanded by households, firms, foreigners, and government at different prices. Its curve relates the “price level” to aggregate quantity demanded.

Now I immediately want to pause and say that I don’t think you can even do this.  This is some abstract basis which they construct, ignoring the fundamental concepts which drive supply and demand.  Then they go and apply it to all products and services at large.  The law of supply and demand only applies to individual products and services.  It can’t be applied to this abstract “aggregate” supply and demand.  I think they’re wrong from the very get go.

Let’s ask ourselves, “What is supply” and “What is demand”, as taught by microeconomics.  Well to create a “demand” curve, you first choose a product.  Say ice cream sandwiches.  Then you list out all these different prices starting with 0.01, 0.02, 0.03 …. 1.00, 1.01, 1.02, …. 3.00, 3.01, 3.02… 10.01, 10.02… and so on.  Then you say, “How many people will buy a box of ice cream sandwiches from the grocery store if they see it there and it costs a certain price.  That’s what a demand curve is.  What is a supply curve?  That’s more complicated.  Basically you take various companies, look at their production methods, how much they’d have to spend in labor costs, raw supplies, and other costs, and then determine how many boxes of ice cream sandwiches companies would be willing to provide at different costs.  Where the two intersect is basically the “market price”.

That makes perfect sense to me.  I’ve ran companies and I’ve sold products to people.  This is all pretty straightforward.  I understand all the different companies, people earning wages, then spending those wages buying products from other companies.  I see the circular flow of it all.

But I don’t get these abstract aggregates.  Think of all the different products and services in an economy.  Some are old and some are brand new.  Technology changes.  Their prices and producers are changing all the time.   It’s insanely difficult just to predict what the demand will be for a SINGLE PRODUCT based on what price you choose, yet we’re going to do so for some aggregate of all products in an economy?   Huge corporations have teams of guys working on answering one question:  How many bottles of Tide will we produce this quarter? If you can simply call what the price of any commodity will do, such as oil or corn, you could earn a killing trading commodities.  But everybody knows you can’t do that, and people who try to make money this way are simply gambling.

Yet somehow these two curves embody the intersection of all products and services supplied, their subsequent demands, and for all possible prices no doubt.  What a weird concept.

So what do these aggregate curves even mean?  I don’t even understand what these curves are really.  I’m guessing they don’t know what these charts are either.  In fact, with economic students I’ve heard from, if you bring up this very question you fail your exams.  They don’t like you to question the mathematical abstractions.  You’re “uninformed” if you do so.  Well, whatever.  The only way I can describe these curves is to vaguely show what numbers they use to calculate them.  That’s about all I can do.

But before I do that, let’s look at what these charts and curves look like.  AS stands for “aggregate supply”, and AD stands for “aggregate demand”.  Notice they intersect.  That’s the “equilibrium”.  When you look along the left side you see “Price Level”.  This is how inflation and price increases come into the picture.  Various economic policies can shift these curves around, and they hope to bring about full employment without inflation.  So, let’s take a look.





Ok.  So how do they generate these curves?  What are we even looking at?  If we don’t understand what the curves even represent, we’ll have a hard time following their arguments.  Well, let’s first discuss aggregate demand using the Mundell-Flemming model.   Here’s the general equation:

Y = C + I + G + X

What do the variables stand for?  Don’t fall asleep on me.  Bear with it for a few minutes.

Y is GDP.  C is consumption (income minus taxes) . I represents investment as a function of the interest rate (an increase in the interest rate decreases investment).  G is government spending.  X represents net exports.

So it’s a sort of aggregate expenditure based on how much money people have after paying their taxes (people spending money), interest rates (which determine investments), government spending (as opposed to personal spending), and exports and imports from foreign countries.  They interrelate the quantities mathematically and form a curve.

I still don’t think this explains “demand”.  This is way too abstract.  That’s really the problem.  Even so, I do get where they’re going with it all.  I don’t agree with it though.

Now let’s discuss aggregate supply.   We’ll talk about long run aggregate supply.   Here’s the general formula for it:

Y*t = f ( Lt, Kt, Mt)

Y is once again GDP.  T represents time.  L represents the quantity and ability of labor input available to product processes.  K represents the available capital stock (machinery, buildings, infrastructure).  M represents the availability of natural resources and materials for production (land).

So aggregate supply is a mathematical formulation of your workers, a valuation of their skills, factory buildings and equipment, and your natural resources such as timber, coal, and stone.

There’s various short-term aggregate supply models, but those are only intended to project the economy in the short-term, and I’m not one to be very interested in short term economic projections.

In order to give this philosophy a fair chance to explain itself, I’ll simply quote a section directly from a Keynesian textbook explaining aggregate supply, aggregate demand, and how they change.

Explaining Aggregate Supply

Look at the economy’s aggregate supply curve in panel a.  [ Note:  If the graphic looks crappy, it’s because I had to draw it in Paint so you’d have something to look at].  Three distinct segments are apparent.  The horizontal segment shows that real GDP can increase up to point a without affecting the economy’s price level.  The upward-sloping segment of the supply curve depicts, from point a to point b, a positive relationship between real GDP and the price level.  The vertical segment marks the full-employment level of real GDP.  All resources are fully employed, so the real GDP cannot increase.


Why the horizontal segment?  For any level of GDP in this range — that is, far below full employment — there are ready supplies of unused resources.  All these idle resources can be put to work before there is any upward pressure on prices.  For example, the economy can increase aggregate supply — the production of goods and services — say from $5 trillion to $6 trillion GDP, without prices going up.  Producers can hire more workers without having to raise the wage rate.  They can use more capital without having to pay higher interest rates because unused capital in the form of unused plant machinery is already available.  As you see in panel a, any increase in real GDP within the range $0 to $6 trillion can occur with the price level remaining unchanged at P = 100.


What about aggregate supply beyond $6 trillion?  It becomes upward sloping.  Increases in output are linked to increases in the price level.  Why?  Because unused resources become less available at higher levels of real GDP.  Faced with the difficulty of finding ready resources, firms resort to offering higher prices for them.  For example, to get more labor, firms are willing to pay higher wages.  These higher wages increase the cost of production, which in turn raises the prices of goods produced.  Beyond $6 trillion GDP, the price level beings to rise above P = 100.  The higher the level of GDP — say, $6.5 trillion — the greater is the economy’s absorption of the dwindling unused resources, and the more intense the upward pressure on the price level.  At GDP  = $6 trillion, P = 110.

The upward-sloping relationship between aggregate supply and the price level can be explained in another way.  Instead of dwindling unused resources pushing up prices, increasing prices can pull up resource costs.  Suppose the price level increases from P = 110 to P = 115.  As the spread between prices and costs widens, producers earn higher profits.  Higher profits attract new firms into production and stimulate existing firms to produce more.  The higher production levels tap into unused resource availability, driving resource costs upward.


When resources are fully employed, aggregate supply reaches an impassable limit.  Full employment is shown in the panel (above) at $7.5 trillion GDP.  At that level of real GDP, producers may try to hire more workers, but how can they?  They can bid away already employed workers from each other by offering higher wage rates.  But what one producer gains in output by hiring a worker away from another, the other loses.  In the end, competition among producers for already employed resources can succeed only in raising the economy’s price level.  Its aggregate supply remains unchanged.  In our example, real GDP stays constant at $7.5 trillion.

Explaining Aggregate Demand

The aggregate demand curve shown in panel b is downward sloping.  For example, as the price level increases from P = 100 to P = 110, aggregate demand of households, firms, foreigners, and government falls from $8 trillion to $6.5 trillion.  Why?  Because increases in the price level affect people’s real wealth, their lending and borrowing activity, and the nation’s trade with other nations in such a way that the demand for goods and services produced in the economy declines.


Consider the effect of a price level increase on the value of people’s wealth, and the effect of changes in the value of wealth on aggregate demand.  Suppose your own wealth consisted of $100,000 held in the form of cash, bank deposits, and government bonds.  You know that, if needed, these holdings can be cashed in, allowing you to buy $100,000 of real goods and services.  In fact, that is how you view your wealth.

But suppose while you are holding these financial assets, the economy’s price level increases.  Videotape recorders that formerly cost $400 now cost $480.  Automobiles that formerly cost $16,000 now cost $18,500.  With prices rising everywhere, what happens to the real worth of your $100,000?  It can no longer buy the same quantity of goods and services, can it?

That is, the real value of your $100,000 wealth decreases.  You feel yourself becoming less wealthy.  And you’re not mistaken!  To replenish the value of your real wealth, you would save more and consume less.  In other words, when the price level increases, the quantity demanded by most people for goods and services in the economy falls.


When prices rise, people find that they need more money just to by the same quantity of goods and services.  How do they acquire that additional money?  Many borrow.  This increased demand for borrowed money raises the cost of borrowing, that is, the interest rate.

Consider the effect of a higher interst rate on aggregate demand.  Few people buy homes with cash.  Typically, high-priced items like homes and automobiles are purchased with borrowed money.

Suppose mortgage rates increase from 10 percent to 15 percent per year.  Monthly payments on a home with a $100,000 mortgage, carrying a 20-year loan at 10 percent, are $965.03.  At 15 percent, these monthly payments jump to $1,316.79.  Wouldn’t that difference cut many prospective home buyers out of the market?

Students, too, feel the pinch of higher interest rates.  Wouldn’t the number of students attending college be affected by higher interest rates on student loans?  Even the quantities demanded of restaurant lunches, concert tickets, and designer jeans are linked to the interest rate.  Many pay for these items with Visa, MasterCard, or Discover cards.  These plastic cards allow people to build up interest-carrying debt.  If interest rates on these cards rise, people tend to cut back on these purchases, depressing the aggregate quantity of goods and services demanded.

Firms’ demands for investment goods are sensitive to the interest rate as well.  A firm contemplating an investment in new machinery may calculate making 15 percent profit on the investment.  If the interest rate is 10 percent, the 5 percent spread between profit and the interest rate may be sufficient inducement to buy the new machinery.  If the interest rate rises to 15 percent, the firm’s demand for new machinery disappears along with the spread, contributing to the decrease in quantity demanded.


Suppose the price level in the United States rises while price levels elsewhere in the world remain unchanged.  Wouldn’t we tend to buy more foreign goods and reduce the demands for our own goods?  After all, when prices for domestically produced goods such as wines, lumber, and automobiles increase while other nations’ prices remain unchanged, wouldn’t French wines, Canadian lumber, and Japanese automobiles become more attractive?  Our demand for imports would rise, and our demand for domestic goods would fall.

At the same time, the French, Canadians, and Japanese would find our now higher-priced exports less attractive.  Many wouldn’t buy them.  The quantity demanded of our goods and services, then, would fall.

Shifts in the Aggregate Demand and Aggregate Supply Curves



The aggregate demand curve relates the quantity fo goods and services demanded in the economy to varying price levels.  A change in the quantity of goods and services demanded at a particular price level, however, is represented by a shift in the curve itself.   [ … ]  What could cause such shifts to occur?

Suppose the government decides to overhaul our economy’s infrastructure.  It programs major construction on highways, bridges, railroad lines, airports, research hospitals, public housing, and other facilities that are in the public domain.  These programs represent new investment demands that shift the aggregate demand curve to the right, from AD to AD’.

Or consider what would happen to aggregate demand when incomes abroad increase.  Canadians, with higher incomes, buy more U.S. imports, shifting our AD curve to the right.  If we decide to consume more goods and services ourselves — even when prices remain unchanged — aggregate demand increases.

What would cause a change in our consumer behavior?  A tax cut could do it, or perhaps changes in our expectations of future income.  After all, if we expect to have more money in the future, we may feel more comfortable about buying more today by borrowing or saving less.

Just reverse the direction of change in these factors, and the aggregate demand curve shifts to the left, from AD to AD”.  For example, a cut in government spending, a decrease in income abroad, an increase in taxes, or an expectation that future income willf all would all tend to lower aggregate quantity demanded at every price level.


One of the principal factors accounting for a shift in the aggregate supply curve from AS to AS’ in panel b is an increase in resource availability.  Simply put:  More workers, more land, more capital, and more entrepreneurial energies — no matter what the price level — result in greater aggregate supply.  The prices of these resources affect aggregate supply as well.  If wage rates or interest rates or rents decrease while the economy’s price level remains unchanged, profit margins will expand, making producers more willing to supply greater quantities of goods and services.

Anything that reduces resource availability or increases the prices of resources would, of course, have the opposite effect; that is, it would shift the aggregate supply curve from AS to AS”.”

So when they were talking earlier about needing an $80 billion dollar stimulus to get the economy rolling, they used this aggregate supply and demand curves to calculate that.  They try to spend money (using G in the aggregate demand equation) to push their AD curve as far to the right as possible hoping to place it just at the price level = 100, which means there’s no inflation.  A sort of perfect macroeconomic equilibrium.

I’d like to point out some very important consequences of this model.  Take for instance their calculation of aggregate demand.  Government spending is considered more productive than private spending when it comes to stimulating an economy.  It has a greater effect in raising GDP during a recession.  They also believe that cuts in government spending can seriously hurt the economy.

It’s amazing how credible economists from different sides can recommend completely opposite policies.  Some economists, such as supply-siders, are telling you to cut government spending to stimulate the economy in a recession, whereas Keynesians tell you to increase it.   That’s why you’ll watch your television and see economists recommending completely opposite policies.

For a long time I wondered how a Keynesian could come to such a conclusion.  Why would a politician, spending money on literally anything (remember from earlier, the President can come up with spending programs within 10 minutes which can fix the economy — it could even be digging ditches, it doesn’t make a difference), close the recessionary gap?

You may be wondering, “What is a recessionary gap?”  Well, I’ll try to explain it.

There’s an intimate relationship between companies investing in inventory which they intend to sell to customers, and people saving money in their bank accounts.  Take a shoe manufacturer.  Say the new year is starting and they’re trying to determine how many pairs of shoes they need to produce that quarter.  They do their estimates and believe they need to produce 20,000 pairs of their running shoes.  They do so but are only able to sell 12,000 pairs, giving them an excess of 8,000 pairs of shoes unsold.  When businesses overshoot demand, producing too much, this leaves them with excess inventory and a deficit in cash-flow, and oftentimes they have to let go of some of their staff, leading to unemployment.

Now what do these unwanted inventories lead to?  Well the next quarter rolls around and the shoe company orders less leather and twine than they did the previous quarter.  This leads to unemployment in other supplier companies.  So it has a chain effect down the line.  If a big corporation which orders supplies from a lot of different companies screws up, badly judging market demand, they can cause havoc on a whole lot of people.

This is a nasty cycle in capitalism.  A lot of people can be laid off from their jobs just because corporate management misjudged market demands, either producing the wrong product or too much of a product.  And it’s not easy to know how many of your products will sell either.  We live in a very precarious world.

Another cause of the business cycle, Keynesians contend, is people saving money.  If people don’t spend their money in the marketplace it just sits idle in their bank account.  Money has to flow.  After all, if people don’t spend the money they earn the businesses in town won’t earn any money either, and then they won’t have money to pay their staff and make payroll, leading to unemployment and pay cuts.  So to Keynesian economists, you saving money is a dangerous thing.  They don’t like it.

They believe in the paradox of thrift.  The more money people try to save, the less people will be able to save because it will only decrease their potential earning ability.  Their income will have to decrease because the companies they work for will earn less money.

This brings us to talks of the income multiplier, which a huge part of Keynesian economics is based.  First we need to know the “marginal propensity to consume”, which is a percentage telling us how much people are spending, and how much they’re saving.  Say they spend 80% of all their take-home pay, and save 20%.  The Marginal Propensity to Consume (MPC) would be equal to 0.8.  The Marginal Propensity To Save (MPS) would be 0.2.

I’ll quote from this same textbook, talking about the income multiplier:

“Let’s follow through the impact on the level of national income of one such technological change, say, a $1,000 investment.

Suppose John Flygare, the owner of a tennis shop in Evanston, Illinois, reads and article in Sports Illustrated describing a new machine that restrings tennis rackets in half the time it formerly took.  The new technology costs $1000.  Suppose John decides to make the investment.

Let’s trace the sequence of events that follows that $1,000 increase in investment.  First, a new order is placed for the machine.  John’s decision to invest represents a new order for Bradley Hastings, the machinist and inventor of the restringing equipment.  He produces the machine, sells it to John, and ends up with $1,000 increase in income.  Of course, John ends up with a new machine.

What do you suppose Bradley does with the additional $1,000 income earned?  Since we suppose MPC = 0.8, we know, then, that he increases his consumptive spending by $800.  Let’s suppose he spends $800 on a custom-made water-bed.

Think about what follows.  The carpenter, Jay Malin, makes the bed and warns $800, which represents for him an addition to income.  Once again, real output and real income are created simultaneously.  And, of course, Jay will do with his new income what Bradley did with his — spend part, and save the rest.  With MPC  = 0.8, $640 of the $800 is put to consumption spending.


The initial $1,000 change in investment spending sets in motion a chain of events that creates — in successive rounds of income earning, consumption spending, and saving — a $5000 change in national income.  And, as you see, it creates also water beds, violins, computers, healthcare, auto repair, space heaters, and a host of other real outputs whose total value is $5000.

Note that as economic activity progresses through the successive rounds, the additions to national income become smaller and smaller.  For at each round, some of the income is set aside as saving.  The lower the MPC (or the higher the MPS), the greater the sum set aside.”

So based on how much money people save, and how much they spend, determines the effect that the money circulating throughout the economy will have.  So now we come to the income multiplier equation.

First we started off with $1000.  That money was given to a 2nd person who got 800, or 0.8 x 1000, and that money went to a third person who got $640, or 0.8 x (0.8 x 1000) and so on. Or…

$1000 + (0.8 x $1000) + [0.8(0.8 x $1000)] + …

Written more generally we get:

$1000 + $1000(MPC) + $1000(MPC^2) + $1000(MPC^3) + … + $1000(MPC^n)

So basically we multiply $1000 times:

1 + MPC + MPC^2 + MPC^3 + … MPC^n

If you know your algebra, this is the same thing as :  (1 / 1 – MPC) and we get the relation

(1 / 1 – MPC) = 1 / MPS  = the multiplier

In this case we get 1 / 1-0.8 = 1/0.2 = 5.  So our multiplier is 5.

But say people only saved 10% of their income instead of 20%.  The multiplier would be 10!

1 / 1-0.9 = 10

Or what if people spent 99% of everything they earned, only saving 1%?

1 / 1-0.99 = 100

And strangely, if we spend everything and save nothing we get:

1 / 1-1 or 1 / 0 = infinity

So if we spend everything we earn the Earth explodes and we instantly become gods transcending all space and time.  Keynes was really onto something here.

The ultimate way to economic prosperity, to Keynesians anyway, is for us all to spend everything we have and we could literally exponentially increase economic output.  The corporations sure love this one.

But this same multiplier also works in reverse.  When the interest rate rises, for example, this may send investments from $100,000,000 to $75,000,000 and the multiplier will work in reverse.  It’s not a loss of $25,000,000 in GDP, but $125,000,000 because our multiplier is 5.

And why is government spending always superior to private spending?  It all has to do with the income multiplier.  If the government takes $10,000 from you and spends it, they didn’t save any of that money.  They spent it all!  So naturally we’ll get the full effect of the money.  But if you would’ve had the money you probably would’ve saved 10~20% of it, and that’s no good.  The money’s not as potent.  GDP doesn’t grow as much as it could have.

And you guys want to know the ultimate way to get GDP rolling strong?  To get our economy out of the slumps during a recession?  Crank out bombs and tanks!  I’ll quote from the text:


Are we destined always to go to war?  From time immemorial, wars have been viewed as innate to the human experience.  Admittedly, the evidence is frightfully confirming.  Whether or not wars can be avoided, economists have long observed a link between wars and business cycles.

Does such a link make sense?  Think about it.  Wars create instantaneous demands for all kinds of goods and services.  once the decision is made to go to war, supporting the war effort becomes high priority.  Armies need to be staffed, fed, clothed, housed, transported, equipped, and mended.

That requires considerable spending.  You can see the income multiplier working overtime.  In each of our major wars — the 1861-65 Civil War, the 1914-19 World War I, the 1939-45 World War II, the 1950-53 Korean War, the 1964-75 Vietnam War — miltary production spurred the economy into rapid expansion.  And in at least some, if not all, of them, the end of war brough ant end to the economy’s war-induced prosperity.”

That’s probably what ol’ George Bush and Dick Cheney were thinking too, but somehow our economy is sucking pretty bad right now and we have wars going with Iraq, Afghanistan, Pakistan… Probably soon we’ll be fighting Iran.  Somehow it’s not working.  What’s wrong?

Take a moment and pause for a second and reflect on these Keynesian policies.  Think of the founding fathers and history in general.  This goes against EVERYTHING that history has taught us.  It’s completely against all traditional wisdom.  We’re being told that high taxes is prosperity.  Wars are prosperity.  Saving money is evil and harmful.  The more the government spends on your behalf, the more prosperous you will be.

Remember the whole “no taxation without representation” stuff?  We’ve had the lowest taxes of any nation on Earth, and we’ve constructed a free society, completely opposite of everything this Keynesian stuff is recommending, and we became the most powerful nation on the planet.  Thomas Jefferson would throw a fit if he saw this.  He’d be screaming his head off.  “Is this what I risked my life for?”  They formed a republic with very little government intervention, and now these policies are telling us that the government is the key to all prosperity?  If we submit all of our money to taxation and government spending, and let them spend our money for us, we’re bound to succeed?

Our banking system has become based around these same theories.  Apply the concepts of the multiplier to banking and you get fractional reserve banking and money flowing out of thin air and us all getting buried in debts.

And everything is pro-war and pro-taxes.  All these Keynesian policies give the politicians more and more money to spend, which is why I personally feel it’s so popular in Washington.  Economy is lagging?  Lower interest rates to the floor!  Banks run wild!  They then do their aggregate demand and supply calculations, criss-cross and come up with how much money they need to spend.  Then come one come all.  Politicians line up!  It’s time to dole out printed money and tax funds!  Don’t worry, you can spend the money on any project whatsoever.  Line up all the unemployed, shave their heads, put them in pink bunny outfits and tell them to dig holes; it all has the same effect on the economy.  Missile contracts to Halliburton?  Special science studies for Exxon Mobile?  New fighter jets for Lockheed-Boeing?  Spend spend spend!

I roll in my bed at night wondering to myself, “What even is this?  You guys aren’t serious?  You ARE serious aren’t you?”  *Gaping mouth, eyes wide open*

They don’t even think in terms of efficiency.  As long as the government spends the money, prosperity is on the way.  The multiplier will work wonders.  Thrift?  Who needs that?  Just keep increasing taxes and government spending.  That’ll take care of the recession!  To them money is magical.  Paper flowing around creates value out of nothing.

Just load up the Huffington Post.  All the economists on there recommend this stuff.  And you know, I don’t even understand how progressives (as they call themselves) can even believe this stuff.  They’re all against the wars, they tell us to pull out because it’s costing us too much money, then they advocate Keynesian fiscal policy.  They don’t even get it.  They should be pro-war, like the Republicans.  But they’re not.  They don’t even understand the economics of the very policies they advocate.   I guess maybe they feel the government should spend that money on something else, yet they still feel it’s not a drain on the society but an economic accelerator?  I don’t know.

And ALL of this stuff is based on these weird abstract concepts of “aggregate supply” and “aggregate demand”.  They don’t even make sense.  A supply and demand curve for all products and services combined?  What?  What even is that?  No wonder they come to such crazy conclusions.

I sometimes consider abandoning all of my science research and dedicating myself fully to the study of economics.  It’d be very fulfilling to one day write the most comprehensive and damning economics textbook ever written, fully blasting Keynesian economics to bits and hopefully to eternal oblivion.  I think it’s an evil that’s destroying free society as we know it.  I had planned to write about all that’s wrong in these theories, but as you can see this entry is already a beast.  I’ll be surprised if anyone reads it all the way to the end.

This is why people didn’t see the housing bubble as it happened.  This is why they don’t see the student loan bubble.  This stuff is just wrong.  It’s wrong at so many levels.  It resembles economics, but then based on faulty assumptions they build an edifice of bullshit that doesn’t even work at predicting events.   It should just be intuitively obvious from history studies that this stuff is wrong.

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