Endless Money

Remembering back to my freshman year of college, I was curious but not enthralled by my macro economics class. The ideas and concepts were interesting, but it didn’t feel as if there was anything miraculous like I was seeing in philosophy, or art classes. That is, until the day we learned about the Aggregate Expenditure Multiplier–even though it was presented as a simple fiscal tool, I walked out of that class brimming with so many questions about the real way to conceptualize ideas in economics. Specifically, I couldn’t come up with an answer to the question:

Why don’t we have infinite wealth as an economy?

In this post we’ll focus on explaining the Aggregate Expenditure Multiplier, then fully tackling an answer to the above question. It begins, as many things in economics do, with John Manyard Keynes. Framed in the era of the Great Depression, the government was desperately looking for ways to raise the populus out of poverty. The government had some small successes by employing people, or by trying to instate welfare programs, but soon found out that one of the most useful tools was actually to just spend money–and this is the foundation of the AEM.

In Practice

For our example, let’s say that the government spends 200 million on building a hospital. Not only will the hospital get built, but suddenly all the workers will have a collective 200 million on their hands to spend from wages–200 spent, 200 earned. Most of them would save a given amount, say 20%, but over the course of the next week the rest of that 200 million would get spent on groceries for example. The process then repeats itself. Grocers now receive a collective income of 160 million (That’s 200 multiplied by the ⅘ that isn’t saved), and will take that money, save some, but then spend most on buying, let’s say, clothing. The point is that despite the government using the original money to make only the hospital, through the use of wages that money is then able to be spent again on millions of dollars worth of groceries, then on clothes, and really on anything else. The sum will slowly diminish as people continue to put it in savings, but that money is able to almost echo through the economy, creating material value over and over and over again. It’s definitely a challenge to fully wrap one’s head around, but I encourage the reader to make sure they grasp the idea before continuing.

There’s actually a way to calculate how much monetary value is created through that original burst of money, and it’s based on what percentage of worker’s wages they are willing to spend. This is called the MPC, marginal propensity to consume, and is mirrored by the MPS, the marginal propensity to save. Together they add up to a whole, like the example 20% saving and 80% spending. All you have to do is divide the original amount by the MPS, and you’ll get the total amount added. So,

Magical, right?

Speedy Dollars

This may be a good time to introduce theories of value for objects in the economy. One popular way to break it down is between use value (How helpful the function of an object is) and exchange value (what it can be traded for). So while a computer has much higher use value than a rock, a diamond has a higher exchange value due to scarcity, aesthetics, and the like. While considering a dollar, it very little use value yet a fixed exchange value–and what’s very important to understand is that the more times a thing is exchanged, the greater total use it accumulates. A five dollar bill passes hands an average of 110 times per year, which essentially means it creates 550 dollars of value each cycle. 550 spent, 550 earned. You can think about it like this–the transaction of buying eggs at the store has no net negative besides the labor that went into it, which isn’t a physical good in itself. If that 5 dollar bill bought eggs three times, 15 dollars worth of eggs would be ‘brought into the world’. But if it bought eggs a hundred times, again discounting labor, you’d have much more value created. An object of exchange value accumulates worth by how many times it is exchanged.

The reader may begin to see how we’re approaching that question of “Why don’t we have infinite wealth”. The aggregate expenditure multiplier is called a multiplier for a reason, and really the only thing holding us back from a much larger number is the amount of money people save. In our previous example if the MPS was 10% instead of 20%, we’d have 2 billion instead of one. And if people saved just 1% of their income, an initial deposit of 200 million would result in 20 Billion dollars worth of goods and services. So what’s holding us back?

Well, from a consumer perspective, you’ve probably been told many times that it's wise to keep money stored away for the future. That could be in terms of an unemployment cushion, college savings, or health insurance. If you only did save 1% of income, the next time a family member broke a leg would become much more troubling with nothing left in savings. And while some pay-as-you-go institutions exist like full coverage health insurance, most families choose instead to keep their growing amount of money in the bank. And this, is where the bank money multiplier comes in.

Approaching Infinite

Most money deposited into a bank doesn’t just sit there, it instead goes to others taking out loans, or making large deposits. This is called fractional reserve banking, where the bank is required only to keep a small portion of your funds–and in America, that number is 10%. So while 10% of say your college savings account physically stays put, the rest will go out to other people looking to start a business, or buy a house. For an example we can say that out of 10 thousand dollars in your savings account, the bank lends out 9 thousand to your neighbor Elizabeth who is trying to start a smoothie business but needs the money for a storefront. The moment that withdrawal takes place, we can immediately see how the supply of money goes up. You still have 10K in the bank, while suddenly Elizabeth has new money that is being put to use. Over the course of the next few years of making money off her smoothies, she can pay it back to the bank and that money can be withdrawn without anyone ever knowing it was gone. And since so many people deposit money in the bank, it can get away with this loaning out as long as everyone doesn’t try to withdraw at the same time. But its effect is incredible–essentially creating that value for Elizabeth to start a business out of thin air. And the multiplier works the same way as before. A 10% reserve requirement for the bank will result in a multiplier of ten as 1/0.1 = 10X.

We’ve now pushed the paradox of money multipliers to its breaking point. We’ve seen that any new money spent in the economy will be multiplied out to infinity, as well as money put away in a bank. Basically, the cost of spending a dollar is nothing because that dollar will go right into someone else’s pocket who can use it renewed, while in the meantime netting a material good. So again, if the ideological object of a dollar can create infinite wealth, why don’t we have ineffable surplus?

The Real World

The answer to that is because we don’t have infinite labor, and this has a really beautiful way of putting transactions into perspective. With the previous example of exchanging 5 dollars for eggs, instead what you are buying is the work, resources, and business that went into it. Elizabeth the neighbor didn’t create wealth out of nowhere, instead the profit she generated through working was enough to compensate for the loan she took out. Because in reality, we really do have infinite consuming power which creates the strong illusion of an infinite dollar–the role of currency caps out at what we can produce as a society. Where the Aggregate Expenditure Multiplier or the Bank Money Multiplier actually comes in are the situations where labor is untapped, usually in the form of unemployment. This may be workers in need of a job who the government can employ to build a hospital, or Elizabeth who couldn’t start a job until she got the peremptory loan. Labor isn’t free, but the cost of utilizing it is. And the reason that exchange value gets higher per times it’s used is because that signifies the speed at which labor gets done.

It can actually be quite problematic when the federal reserve uses excessive spending when unnecessary, especially with the nature of these multipliers. Economists have the concept of Potential GDP (Gross Domestic Product), which is the highest number of goods an economy could produce if everyone was employed and working to their capacity. When the government puts large sums of money in people’s hands, demand on the whole increases to an amount past that potential line–leading to a lot of imbalances in the market that ultimately lead to inflation. For example, whereas beforehand people would only buy the amount of groceries that they sufficiently needed for the sake of budgeting, with excess money in their hands they’d be much more likely to buy more than producers can keep up with, thus forcing producers to raise their prices. Another side effect may be an influx of producing things grossly unimportant–because there’s lots of money flowing around, people may be able to artificially afford cruises, or pelotons, just for it to affect them negatively later when the subsequent inflation takes place. We can all see this played out with the example of an incredibly expensive wedding–yes, if the marriage couple spends half a million dollars, it isn’t wasted because that money goes into the hands of the wedding musicians, or flower planners, or venue managers. But what does become wasted is the way in which we manage our scarce resources because all that expensive food, or property, could have been going to those who needed it much more. The value in money isn’t to conjure up more product, it’s to designate how labor should be allocated. And when there is too much money in the economy, that ability can get turned around quite quickly.

Another very apparent example of this process is the ongoing inflation coming out of the pandemic. It was a scenario with less supply available but constant welfare spending from the government–obviously it was necessary for many people to get through those years, but now we’re forced to deal with the recesses of labor catching up to just how much money we spent without producing much labor. If we spent a lot during Covid with just inefficient work-from-home jobs, now we are forced to spend very little while working quite a lot.

If that was a lot to process for readers new to economics, it’s completely alright. The main takeaway is that even though we fiscally have the power to seemingly raise the spending power of money, often the power to produce can’t match up. The Aggregate Expenditure Multiplier, as well as the Bank Money Multiplier, are incredibly helpful tools that help the Federal Reserve know just how much money to spend–if we have an inflationary gap of 1 Billion, it actually makes much more sense to spend 200 million instead of the full amount.

It also taught us a valuable lesson about relative value, that the economy moves at the pace of which the dollar circulates. It's a reflection of how fast labor gets done, and too much circulation will lead to unnecessary spending and subsequent inflation. Hopefully this can give perspective to the next time you hear about any given government spending program, or even the next time you buy a carton of eggs.

Works Cited

"The Multiplier Effect and the Recessionary and Inflationary Gaps." PRINCIPLES OF ECONOMICS: SCARCITY AND SOCIAL PROVISIONING (2ND ED.), compiled by Rice University, 2016.

"What is Value? | Smith, Ricardo, Marx | Keyword." Youtube, uploaded by David Guignion, 21 Sept. 2021, www.youtube.com/watch?v=KSq3Tb36Ryw&ab_channel=Theory%26Philosophy. Accessed 24 July 2023.