The famous economist Keynes claimed that aggregate demand, and
therefore output, can be boosted by government funding of useless
projects, like 'digging holes'. He also claimed that welfare or
transfer payments were not a form of governemnt expenditure, and
therefore could not be used to boost demand nor output. What are the
mechanisms that makes 'digging holes' expenditure effective and
welfare payments ineffective?

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Request for Question Clarification by elmarto-ga on 11 Jun 2003 19:43 PDT

Hello bomber,
Are you sure Keynes claimed that welfare payments were not a form of
government expenditure and thus it couldn't boost demand? Paying
people to dig holes and cover them afterwards seems equivalent to
giving them a welfare payment.

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Clarification of Question by bomber-ga on 11 Jun 2003 20:08 PDT

Hello elmarto-ga
My understanding is that welfare payments are transfer payments, a
form of negative tax, and therefore not part of government expenditure
(G).

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Request for Question Clarification by elmarto-ga on 12 Jun 2003 14:01 PDT

OK, you're right in that welfare payments can be considered as sort of
a "negative tax" (a subsidy) instead of government expenditure.
However, according to Keynes, consumption demand depends on disposable
income, which is, basically, total income minus taxes. A "negative
tax" would therefore reduce the tax burden on consumers, thus rising
their consumption demand. This rise would in turn cause the desired
effect of boosting aggregate demand and output.

If you could provide the context in which Keynes said that welfare
payments are ineffective to boost output, maybe I could come up with
an answer.


Best regards,
elmarto

Hi bomber,

Thanks for an interesting question that made me dust off my economics
books.

The answer lies in the definition of the investment component of the
aggregate demand function.

As I'm sure you're aware, Y = C + G + I + (X - IM); for more of an
explanation of this equation, see this FAQ for principles of
economics:
URL: http://go.dbcc.edu/learningcenter/eco5.html

Of importance for us is the fact that the I in this equation
represents only business investment.

When the government makes a transfer payment to me of $x, aggregate
consumption C increases by my marginal propensity to consume (MPC)
times $x.

Marginal propensity to consume is the proportion of the increase in
income (ie from a transfer payment) that is spent (as opposed to
saved), as explained in the economics faq linked to above.

Thus, direct government spending on digging holes increases aggregate
demand by the amount spent.  However, government transfer payments
increase aggregate demand by only the marginal propensity to consume
times the amount of the transfer.  Because marginal propensity to
consume may be very low if people are saving a lot in anticipation of
rougher times ahead, transfer payments can be very ineffective.
 
I hope you find this information useful, and feel free to request 
clarification.  If you do require clarification, please allow me to 
provide it before you rate this answer. 
  
Hoping I was helpful,  
  
not_you-ga

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