I just want to make a quick note on the multiplier and the theory of liquidity preference that is not generally recognised. When the full implications of this argument are recognised and integrated with marginalist theories of savings and investment (including the Austrian theory) these theories basically fall apart unless some very restrictive assumptions are put in place.
In his book The Years of High Theory, GLS Shackle sums up the problem of the multiplier nicely and succinctly as such,
The Kahn Multiplier multiplies extra income not matched by extra consumable output, and it is of no consequence to the people of one country, seeking a means to increase their own employment, whether that original extra income is generated by the extra output of tools, or of goods for export uncompensated by extra imports, or whether it is a free gift of the government or private philanthropy. Kahn chose road-building as his example, doubtless because it is unnecessary to explain that roads cannot be sold to consumers. (p. 186)
This gets right to the heart of the matter and Shackle highlights precisely the sentence that is most important so that I don’t have to. When investment is increased new consumer goods do not become available immediately and thus the multiplier effects generate income and consumption that must be matched by the current output capacity of the economy or else they will cause inflation.
Now, here’s the problem for marginalist theory: if the economy is operating at full capacity, as is the typical case in a marginalist model, then how does an increase in investment not lead to inflation? The answer is familiar to any undergraduate who has done his homework: the new investment must be stimulated by a rise in savings. The process here is conceptualised as one in which the causality runs, not from investment to savings, but rather from savings to investment.
Economic actors decide that they will decrease consumption and increase savings. This lowers the rate of interest and investment increases. Thus the multiplier effect that the investment produces is offset by the rise in savings that precipitated the rise in investment (in formal terms cY is offset by sY). Down the road, when the savers go to spend their savings they will find that the extra productive capacity that their invested saving has brought online will allow them to increase their consumption in real terms (i.e. without price increases)**.
