### Understanding the Balanced-Budget Multiplier Theorem

Scott Sumner recently linked to David Henderson who cited the following comment by Professor T. Norman Van Cott of Ball State University to an op-ed by Alan Meltzer trashing Keynesian economics.

Particularly egregious is something labeled “the balanced budget multiplier.” To wit, an equal increase in government expenditures and taxes leads to an increase in national output equal to the additional government expenditures and taxes. Mr. Samuelson, et al., gives the notion a scientific aura by packaging it in equations and graphs.
Economic surrealism? You bet. Note that national output and taxes rising by the same amount means producers’ after-tax incomes are unchanged. How or why would producers produce more for no increase in after-tax income? Hint: They won’t. Never mind the smoke screen of graphs and equations.

I posted the following comment on Henderson’s blog, but my comment came three days after the previous comment so no one seemed to notice.  So I thought I would post it here to see what people think.

David, Just saw a link to your question on Scott Sumner’s blog. I think that the simple answer is that the balanced-budget multiplier presumes that there is involuntary unemployment. The additional output is produced by the employment of those previously unemployed; those previously employed experience a reduction in their real wage. I am not necessarily endorsing the analysis, but I think that is logic behind it.

A further elaboration is that under Keynes’s definition of involuntary unemployment, the way in which you re-employ the involuntarily unemployed is by raising the price of output while holding the wage constant.  So, under Keynes’s (economic) logic you need inflation to get the involuntarily unemployed reemployed.  That logic somehow gets lost in “the smoke screen of graphs and equations.”

#### 4 Responses to “Understanding the Balanced-Budget Multiplier Theorem”

1. November 8, 2011 at 10:29 pm

We’ve been over this before, but the balanced budget multiplier has *no* implications about real wages for those already employed. If the marginal product of labor is steeply declining over the relevant range, the real wage may fall. If reduced unemployment improves the bargaining position of workers, the real wage may rise. But the logic of the balanced budget multiplier is the same regardless.

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2. November 8, 2011 at 10:33 pm

(And yes, Keynes did say in the General Theory that a fall in unemployment would involve a reduction in the real wage. But he subsequently accepted the criticism of Jacob Viner and others that this was a mistake, and reversed his position in his (I believe) last scholarly publication, a 1939 article in the Economic Journal. The claim that higher employment must be accompanied by a lower real wage, he said, “is the portion of my book which most needs to be revised.”)

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3. November 9, 2011 at 10:48 pm

Jw, Here we go again. But I am not going to argue with you this time. I was just providing one way to think about the balanced budget theorem. There may be others. But I think the existence of involuntary unemployment is necessary to generate the result.

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1. 1 I Figured Out What Scott Sumner Is Talking About « Uneasy Money Trackback on January 16, 2012 at 6:01 pm

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David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan