The fundamental trouble with the formula multiplier is that it is too simple to reflect consumers’ actual purchasing habits. It is far too facile to suggest that an increase in, for example, government spending can simply be fed through a multiplier to give the increase in consumer expenditures. In fact, the relationship between the two may not even be linear at all, but this is a possibility completely not accounted for in the model. However, when comparing the size of the recent stimulus package to the actual marginal propensity to consume, one thing is clear: it is not that the package was too small. Rather, it is that the formula is fundamentally flawed both theoretically and especially in relation to real-world economics. If the Keynesian three sector model worked, it would have given good results when policies were based upon it during other recessions, but simply determining the size of a stimulus package based on the marginal propensity to consume is not a sound way to go about determining policy.
Given historical trends for the United States of America’s unemployment rate, the idea that the natural rate may simply be higher than expected is reasonable to entertain. The differences between the United States and Europe in terms of this rate can be accounted for in part by differing worker protection laws between the two areas of the world. European workers, it is well known, enjoy greater limitations on overtime hours and far greater vacation time lengths than those in the United States. Perhaps some portion of those unemployed in the United States are those who simply “burned out” of a previous job due to unreasonable expectations. As competition for work gets more fierce, the problem is only exacerbated, for employers come to expect that their desperate employees put in unpaid hours and make fewer mistakes while on the job. There may be a certain segment of the population that would be able to meet lower demands, but that means spending more time unemployed when conditions are harsher. This could account for both the recent change in the “natural” unemployment rate in the United States and for the lower rate in Europe.
The economy cannot truly be spoken of as “knowing” it is not in equilibrium, but the factors involved do tend to adjust themselves according to macroeconomic principles. If income is high in relation to the equilibrium state, spending should rise, putting this income back into the system. Once the amount of income flowing around the system no longer changes over time, the system is again in equilibrium at a new level of circulating income. At this point, there is no longer any impetus to change, and increases cease.
The reason that changes in taxes and changes in government spending do not simply “cancel out” is that taxes do not decrease the consumption on a dollar-per-dollar basis. Instead, the multipliers involved complicate the matter. This is what causes the difference in the vertical distance shifted up versus down.
For the circular flow model, if investment increases, the level of income will increase, because investments are an injection. If imports increase, the level of income will decrease, because these are a form of leakage; it is like giving another country some of the income. Conversely, if exports increase, the level of income will increase, for the same reason but in the opposite direction. Savings are a form of leakage, since they put money aside and out of circulation, so if savings increase, the level of income decreases. Leakage also occurs from taxes, so the level decreases there, too. Conversely, government spending increases the level.
If the level of savings exceeds the level of spending, in the Keynesian model, the aggregate expenditures will decrease. This is because savings have decreased consumption without investments being able to compensate for the shift. In the Classical model, the level of income decreases, which is a similar concept, but not identical.