"Multiplier effect" and interest rates

Two aspects of Keynes's model had implications for policy:

First, there is the "Keynesian multiplier", first developed by Richard F. Kahn in 1931. The effect on demand of any exogenous increase in spending, such as an increase in government outlays is a multiple of that increase-until potential is reached. Thus, a government could stimulate a great deal of new production with a modest outlay: if the government spends, the people who receive this money then spend most on consumption goods and save the rest. This extra spending allows businesses to hire more people and pay them, which in turn allows a further increase consumer spending. This process continues. At each step, the increase in spending is smaller than in the previous step, so that the multiplier process tapers off and allows the attainment of an equilibrium. This story is modified and moderated if we move beyond a "closed economy" and bring in the role of taxation: the rise in imports and tax payments at each step reduces the amount of induced consumer spending and the size of the multiplier effect.

Second, Keynes re-analyzed the effect of the interest rate on investment. In the classical model, the supply of funds (saving) determined the amount of fixed business investment. That is, since all savings was placed in banks, and all business investors in need of borrowed funds went to banks, the amount of savings determined the amount that was available to invest. To Keynes, the amount of investment was determined independently by long-term profit expectations and, to a lesser extent, the interest rate. The latter opens the possibility of regulating the economy through money supply changes, via monetary policy. Under conditions such as the Great Depression, Keynes argued that this approach would be relatively ineffective compared to fiscal policy. But during more "normal" times, monetary expansion can stimulate the economy, mostly by encouraging construction of new housing.