Friday, January 23, 2009

Keynesian stimulus, NOT

Income (Y)=Consumption (C)+Investment (I)+Government spending (G);

Consumption (C) is a fraction "c" of disposable income, income(Y) - taxes (T).

The above equations (Keynesian model) imply that Y=[I+G-cT]/(1-c), or that tax cuts will raise income by the factor c/(1-c), the so called "multiplier." As my income goes up, I buy stuff, which raises the income of the sellers, and they buy more stuff, and so on. The net multiplier is c/(1-c), estimated to be around 1.5.

HOWEVER, last summer's rebates failed to have the predicted effect. In the graph below, the increase in disposable income failed to raise consumption. The Keynesian stimulus failed becaise consumers perceived the tax cuts as temporary and decided to save rather than spend.

1 comment:

  1. This is an interesting topic. Apparently Obama's plan is to distribute the rebate incrementally by reducing income tax witholding rather than in one lump sum. They'll be more likely to be spent that way, rather than saved, because it should help to counteract the effect you mentioned. It's an interesting theory anyway. There's a decent article on the subject here: