On the concept of exogeneity and multiplier

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?On the concept of exogeneity and multiplier

The concept of exogeneity and related concepts, such as exogenous shock, play very important roles in economic theory and policies. When economists couldn’t or don’t want to explain something, they blame it on some exogenous factors.

The increase of oil prices in 1973 was a classic example of exogenous shock in economic literature.  But was the oil price increase really exogenous?

In 1971, Nixon closed the gold window. US government no longer exchanged US dollar to gold at a fixed rate. After that, the price of gold, a major commodity, increased sharply. Oil is the most important commodity. There was a great pressure for oil price to rise as well. The increase of oil price is endogenous, not exogenous.

If so, why is the standard explanation of 1973 oil price increase still exogenous shock? There could be many reasons, which we will not explore further here. But by calling oil price change exogenous, economists missed the intimate connections between oil and the overall economic activities. Indeed, there are few important factors in economics that are genuinely exogenous. No connection discovered doesn’t mean no connection existed. It is extremely arrogant, and ignorant, to call the price change of oil, the driving force of most economic activities, as exogenous.

Now let’s discuss the term multiplier. The following is the definition of multiplier.

In macroeconomics, a multiplier is a factor of proportionality that measures how much an endogenous variable changes in response to a change in some exogenous variable.

The definition of multiplier involves the term exogenous variable. We have just stated that few, if any, important economic factors are truly exogenous. Hence, the concept of multiplier is meaningless according to the standard definition. We can further elaborate this point by looking at government spending, the most important multiplier in economic literature. 

Can government spending be truly “exogenous”? Many people point out government spending will “crowd out” private spending. We might debate that. But calling the omnipotent government exogenous is an enormous understatement of government power.

From our discussion, few, if any, important factors in economic activities are truly exogenous. As a result, multiplier, defined through exogenous factors, is meaningless. In my opinion, the term exogeneity should be abandoned and the term multiplier should be redefined.