A Keynesian Conundrum
By Bryan Caplan
This year, I’m prepping my 8th-grade homeschoolers for the Advanced Placement tests in European History, Microeconomics, and Macroeconomics. The Macro test is less Keynesian than it used to be, but its Keynesian origin remains blatant. And after years away from the simple Keynesian model, I noticed two things I never noticed before.
But first, let’s back up. In the simple Keynesian model, recessions can be overcome by raising government spending or cutting taxes. In general, however, Keynesians prefer the former approach. Why? I’m sorely tempted to accuse them of leftist bias, but they’ve got an elegant response. Namely:
Define people’s Marginal Propensity to Consume out of a new dollar of income as MPC.
Then if you increase government spending by $1000, nominal GDP rises by $1000 + MPC*$1000 + MPC^2*$1000 + … = $1000/(1-MPC),
If you cut taxes by $1000, however, nominal GDP only rises by MPC*$1000 + MPC^2*$1000 + … = $1000*MPC/(1-MPC).
If they have to cut taxes, similarly, Keynesians prefer to cut taxes on the poor. I’m sorely tempted to accuse them of leftist bias, but once again, they’ve got an elegant response. Namely: Poor people have a higher MPC than the rich, so tax cuts for the poor give you more bang for your buck.
But what if your problem is not recession, but inflation? Then both of the preceding arguments reverse. In terms of the simple Keynesian model:
1. Cutting government spending is a better way to reduce inflation than raising taxes.
2. Raising taxes on the poor is a better way to reduce inflation than raising taxes on the rich.
I’m pretty sure I’ve never heard any Keynesian policy analyst say either of these things. But they flow out of the simple Keynesian model just as naturally as their stock anti-recessionary recommendations. If leftist bias isn’t the explanation, what is?
Update: Interfluidity said some of what – until now – I’ve never heard any Keynesian policy analyst say.