Question

In a small, rather isolated community of mostly recent refugee immigrants, the eco-nomic situation is very depressed and a large fraction of the adult population findsitself unemployed. A young, Columbia-trained economist then suggests that givingmoney transfers to refugees might be a great idea. She explains: “I have studied thesepeople’s consumption behavior and they seem to consume a large part of any incomethey receive, maybe even 90%. So I think overall income in this community might riseby around $5 for each $1 we give to refugees, which is a huge return on the money we give.” (a) Is the economist right, based on a simple application of keynesian multipliers? If so, explain why. If not, explain what a better answer may be. (b) Regardless of the precise answer, describe the mechanism whereby the multiplication effect would occur in the small community.

Answer 1

a) According to the Keynesian multiplier, this economist is right with her statement.

Explanation - According to Keynes, increased government spending on new projects will generate more revenue for the government. This is because the new government project will provide jobs to people, and promote economic growth. As people will be left with more money to save, new businesses will grow as they will have better credit facilities from the banks. So now these new businesses will also hire people who will earn wages and save a certain portion of their money which will again promote investment with more new businesses. And this will generate more revenue for the government. So we can see that once the government starts a new project and spends for the economy, this promotes social and economic welfare and boost savings and investment, which in the form of a multiplier promotes the growth of the economy rapidly, generating higher revenues for the government and collection of more taxes. So according to the Keynesian multiplier, increase in private consumption expenditure, investment expenditure and government expenditure will raise the Gross Domestic Product (GDP) by more than the number of such investments and expenditures. Keynes believed that an increase in output in the economy and attainment of full employment will generate more demand for the products and services in the economy. And businesses will try to make new products for such an increase in demand. Keynes says that with spending of a given amount, the value of the total output is more than the amount spent.

In our example, the isolated refugee immigrants are in an economic depression with severe unemployment. So in such a situation as the economist suggests the government provide the refugees with benefits of $ 1 to promote the community and fight depression. If the government spends money on these refugees, it will generate more income for them, and they will get some money to save for their future needs. So once they start saving, new businesses will emerge utilizing the saved money in the form of investment for their businesses. So now there will be the creation of employment which will help the adult refugees to get employed and earn more. As they will earn more they will be able to lead a better standard of living with more saving and more consumption. So this will again create more business opportunities and innovation of new products. This will also increase the demand for products in the community. So the economy will be boosted and this will generate more revenue for the government. The Keynesian multiplier is basically based on the theory of Marginal Propensity to save and Marginal Propensity to Consume. So when a person is left with more income after providing for his/her consumptions, the person saves the surplus amount to gain interest income. So the expenditure spent on such refugees will generate more revenue and promote economic growth.

b) If the Government increases its spending in the local community, there will be an increase in the income of the people which will generate more savings and investments within the local economy. So the people within this small community will get a better income and facilitate more purchasing power. With more government investment in the community, there will be a creation of new job opportunities. These jobs will facilitate community members to earn more and lead a better standard of living. With increased income, they will have enough money to save and these savings will generate investment by way of loan to producers, which in turn will be invested in new products and services promoting the economy and the community as a whole. The government will get more revenue from this higher income group and the new businesses which will increase government revenue in the form of taxation. There will be a multiplier effect in the economy with increased government spending which will create better jobs, better living standard, better products, more investment, and generation of more government revenue within the nation and at local levels. So this multiplication effect within the small community will promote economic growth and development within the community and promote the society towards better future. Both the manufacturing and service sector should be facilitated with better opportunities and promote new businesses to get a better result within the community.