A group of boys play ball in the street. In the struggle, one of the children clears the ball with such force and bad luck that he goes straight to breaking one of the largest windows of the town school.

Disturbed by the noise, a group of neighbors comes to the scene and, as could not be otherwise, harshly reprimands the boy for having destroyed the window. Football is a good habit, but keeping the glass from breaking is also a good habit.

The words multiply, most of them think that children should not be allowed to play with the ball in the street. Even one of the school teachers, who lived nearby, suggests that the school itself should give him an exemplary punishment.

However, an elderly man who was listening argues: “I don't understand why they want to punish the child. You should rather reward him, since what he did will benefit all of you.” Those present doubt, but are prepared to listen to his explanations, more out of respect than out of conviction.

The man explains. “Surely the school will need to quickly repair this window, an arrangement that will have to be paid for by the child's father. This will generate a profit for the glazier, who will surely earn some good pesos for the work.

But at the same time, the glazier will be able to use that money to paint his house, for example, because we all pass by there and realize that it needs a coat of paint. That would probably particularly benefit you Mr. José, who is a painter.”

He said, pointing to a brown-haired man who was at the back of the group of people who were complaining about the harm to the child. “I think it wouldn't hurt to be able to do that job.”

“But it doesn't end there. You would then have the possibility of using this money to invite his wife, Mrs. Celia, to dinner. “This money would probably be enough to go to dinner at Luigi's Restaurant, for example.” He said, while pointing to Luis, who was also in the crowd and was the owner of the restaurant.

“And you in turn, Luis, could use that money for your general expenses, which if I'm not mistaken you carry out in Miss Laura's warehouse.” And he pointed again to one of the women who was among the audience present.

“The increased sales will benefit both your suppliers and yourself, who will be able, for example, to buy better school supplies for your child who is starting first grade next year.

And of course, this will benefit the owner of the school bookstore, who in turn will also spend his income as he decides.

“As you see, this child has not done anything wrong, on the contrary, with his action he has boosted the economy of our town, generating greater income for all of us.

And in the long run, also generating more employment, given that many of these products that we mention are manufactured locally.”

In this way, those present agreed with the old man and left the boy alone, convinced that it had been lucky that the boys decided to play soccer right in that place.

Now, is it really like that? Because surely the intuition of many will be telling them that the child should be reprimanded. However, the old man gave some very convincing arguments.

Let's now think about this issue in economic terms. The questions we could ask ourselves are the following:

1. What assumptions must be met for the old man to be right?
2. In which case does the effect represent a price increase?
3. In which case there is no impact on the economy?
4. In which cases is there no immediate impact on the economy, although there may be a negative impact in the medium or long term?

That much-mentioned concept, which we call the Keynesian multiplier

The original text aims to explain a well-known concept in economic literature: that of keynesian multiplier.

It demonstrates how an increase in spending in an economy leads to a more than proportional increase in national income. The explanation that the old man gives is quite clear in this regard, but we can – and must – increase his level of technicality.

In the Keynesian model, entrepreneurs respond by selling all the products necessary to meet demand. The increase in demand is met -at first- by a liquidation of stocks. Once these begin to reduce, business owners will want to replenish the desired stock level, increasing production.

Thus, in the goods market, imbalances between supply and demand are closed based on the response of businessmen, who increase production. In turn, increasing production increases income, which leads to greater disposable income in families.

But the story does not end there. A proportion of the new income is used for consumption, which leads to a new increase in aggregate demand, which will again reduce stocks and cause an adjustment in production.

Let's put numbers to the above. Let's assume an initial expense of $1000 and that - on average - families spend 80% of their income on consumption. The increase in spending leads to an increase in aggregate demand of the same magnitude, causing entrepreneurs to increase their production by $1000.

Now, this also represents an additional income of $1000 for families, who consume 80% of it. That is, consumption increases by $800 due to the new income, generating a new increase in aggregate demand.

Once again, the demand for goods exceeds their supply, generating a decrease in stocks, and a response from businessmen to increase the supply by $800. This represents a new increase in income of that magnitude, of which families will consume 80%, that is, $640.

 How big is the multiplier effect? We can see that the chain of increases follows the formula:

Solving, the final effect ends up being:

A little mathematics will allow you to notice that the greater proportion of their income that families consume, the greater the final increase in production will be.

The concept of the multiplier was widely used to justify increases in public spending during times of crisis. This explanation was given by John Maynard Keynes (1883 – 1946) to show that state intervention would multiply the impact on activity.

Likewise, the application of this type of policies would help to get the North American economy out of the crisis that began in 1929. It is also worth clarifying that these were implemented prior to the publication of Keynes' work.

But before continuing, it is interesting to note that the increase in spending is entirely financed by the saving. That is, an increase in spending (be it consumption, private investment or public spending) is financed by an increase in savings (private or public). Hence, in Keynesian models, “investment creates its own savings.”

What assumptions must be met for the old man to be right?

1. It must exist unemployment In the economy. In this particular case, for example, the glazier must have free time to carry out the work entrusted to him. The same applies to the painter, and to any other agent. In turn, the companies that manufacture the goods that are purchased in the warehouse and bookstore must have sufficient idle capacity to increase production.
2. The father of the child must actually increase your total spending to pay for the broken glass. If you simply skip buying a few things to spend on fixing the glass, you might think the net effect would be zero. That is, a redistribution of the objects of expenditure would occur, but without an increase in it.
3. Even if the child's father saved part of his income and after this event increased his total spending, to ensure that the impact on the economy is positive, it must be evaluated how it was saved said money in advance. In particular, we would need to assume that you store it in a stocking or under the mattress, in order to ensure that the impact is positive. On the other hand, if the savings were deposited in a bank, it is not necessarily true that the level of activity will grow.

Breaking down assumptions: What would happen if there were no unemployment in the economy?

If the first assumption is lifted, the Prices instead of activity level. The glazier (or some other individual in the chain) decides to increase prices to take the job, discouraging other clients. This way, you don't work more, but only get paid better.

But the level of activity does not increase, because its higher income is offset by higher customer spending, so consumption in general is not affected.

This occurs because when demand increases for goods whose production cannot be increased in the short term, the owners of said goods value them more and begin to raise prices. This is what is commonly known as a “reheat” of the activity.

In all classical and neoclassical models, which assume full employment (or at least a low equilibrium level of unemployment), an artificial boost to spending is entirely absorbed by an increase in prices. This increase reduces the disposable income of the majority of the population, so less is consumed and the initial impulse is nullified.

That is why it is commonly advocated to carry out what is known as countercyclical policy. That is, when the economy is depressed, an increase in public spending can help restore the level of activity.

On the other hand, at levels closer to full employment, much of the effect will translate into higher prices and not an increase in production.

Demolishing assumptions: What would happen if there is no increase in total spending?

If we lift the second assumption, nothing simply happens at the activity level. But people's wellbeing is reduced. This is surely the simplest explanation, but surprisingly the one that most escapes common sense statements. Not every increase in spending on a particular item implies an increase in aggregate spending of the same magnitude.

In this particular case, it is possible that the boy's father makes ends meet, and because he has to pay the repair to the glazier, he must stop paying for other goods, harming other agents who will see their income reduced and therefore Therefore they will consume less, giving rise to an inverse multiplier effect.

Drawing a parallel at the macroeconomic level, it is worth asking every time the state (or other agent) increases its spending: how does it finance it? If an increase in public spending is financed by taxes, then the population will have less money to consume.

This can fully or partially offset the increased spending generated by the government. In general partially, given that the private sector will not only reduce its consumption, but also its savings.

Some theorists have gone so far as to assume that an increase in debt-financed spending also has a negative effect on private consumption.

Because? Because it is assumed that completely rational and calculating agents will realize that the state is incurring a debt and therefore must increase its taxes in the future to pay it.

So, anticipating this, they “soften their consumption”, stopping consuming a little in each period to alleviate the blow they will receive at that moment. This theory is known as Ricardian equivalence, but the reality is that it has been widely refuted by empirical evidence.

A clarification is in order. In this case, although the level of activity is maintained, well-being is reduced. Because? Basically because resources are used inefficiently.

Wouldn't the father have preferred to spend his money on something else? Keynes gave a famous example in his "General Theory", which said that if necessary the government should hire people to dig wells and then cover them again, for the sole purpose of generating employment.

Of course, this does not imply that all work is the same, wouldn't it be better for everyone to have them doing something useful? Let's not forget that greater well-being is not just greater activity.

Breaking down assumptions: What would happen if the new income was deposited in the bank?

If we lift the last assumption, that is, if the father deposits his money in the bank beforehand, it is possible that the level of investment will actually be reduced and future production will be affected.

This happens because when banks have a lot of liquidity available to lend, they reduce the interest rate on loans and therefore increase the profitability of investment projects.

The result is greater private investment. If the child's father must withdraw savings to meet the expense, banks have less money to lend, they adjust the interest rate and therefore the investment falls. This compensates for higher consumption and reduces the impact on activity.

Drawing a parallel with macroeconomics, this is what is known as crowding out effect. In this case, a government that must finance itself internally to increase its public spending competes with the private sector for these loans, raising the interest rate and reducing investment. In this way the effect on aggregate activity is smaller.

Anyway, this is the most discussed concept. Classical economists assumed that the crowding out effect was complete since all available savings were saved in banks (or bonds) and the banks lent all available savings and the interest rate rose as much as necessary for the reduction in investment. equal to the highest public spending.

On the other hand, other economists propose that the banking system has the capacity to produce money out of nothing, given that it is not usually lending at its maximum capacity. In that case, increased spending does not necessarily crowd out investment.

To conclude, is the old man right?

The arguments expressed here explain in which cases fiscal policy is more or less effective as a weapon to increase the level of activity. Precisely, much of what led us to write this article is a certain fanaticism for or against fiscal policy, taken as a slogan.

In Argentina, Keynesian models tend to be especially popular in universities, which makes less critical students believe that problems can be solved by spending.

On the other hand, in other parts of the world, economists have found so many deficiencies in this policy that they do not even consider it, leaving monetary policy as the only intervention option.

In any case, it must be clear that - as is usual - there is no single answer, at least from theory, and each particular case should be studied in detail.

Turning a set of policies into an application slogan for all times and places can simply generate effects contrary to those desired.

In short, a technical analysis will be necessary so that good intentions can remain good intentions.

To learn more visit:

Turner (2013). “Debt, Money and Mephistopheles: How do we get out of this mess?” [Click aqui]