– So in this video segment, I’m going to talk about what’s

called the Multiplier Effect. And let’s go ahead

and imagine a scenario that goes something like this. The government decides

to spend $96 billion more than people thought. How much does this affect

aggregate demand? Well, at the very least, this causes

government spending, G, to go up by $96 billion. But remember, that government

spending is income to someone. So let’s suppose the government

decides to spend this much on, you know, building a new highway

from Chicago to Seattle. So a bunch of contractors get

paid, and the workers, and so on and so forth, and the people

who made the asphalt and, you know, all the people

in the supply chain to supply those goods get paid. So there’s $96

billion extra income for the suppliers and workers. And typically we see that

when people get extra income, they spend that income. Maybe not all of it,

maybe some of it. Suppose on average the, what we call Marginal

Propensity to Consume is 75%, which of course

if the same as three-quarters. So if the Marginal Propensity to Consume is if you got

one extra dollar of income, what would be your likelihood

or propensity, so marginal means extra,

right? Propensity means likelihood. What amount would you increase

your consumption spending by? And we’re saying here,

that, you know, we’re just picking a number here

to make the example work, but that people would raise

their consumption spending by 75 cents for every dollar

of income that they get. So when people have $96

billion of extra income, we get an increase

in consumption spending of, 96 times three-quarters, and that should be $64 billion. And so now we have aggregate

demand rising by $96 billion, plus an extra $64 billion. But this $64 billion worth

of consumption spending is income to someone. So people at retail stores

and the suppliers of the goods, and so on and so

forth out there. And they are going to go ahead and increase

their consumption spending by whatever three

fourths of 64 is. And that is 48.

And then that is income to someone else out there. And they’re going to increase

their consumption spending by three quarters of 48,

which is I think 36. And so on and so forth

down the line. So the overall increase in

aggregate demand is 96 plus 64 plus 48 plus 36,

and so on down the line. The mathematics sort

of get into infinite series and so on and so forth, so I ask you to trust me

on the following point that at the end

of this whole process, the overall increase in

aggregate demand is going to be one over the Marginal

Propensity to Consume, sorry one over one minus the

Marginal Propensity to Consume, times the change

in government spending. So in our particular case, it’s one over one

minus three quarters times 96. Which is one over one

quarter times 96, which is four times 96,

or what is this, 384 maybe? Okay, so double check that on your calculator,

I think that’s right. So the overall average increase in aggregate

demand is about 384. So if we were drawing this, what we’d say here is this much

might be the increase in G. So initially you might think

that the aggregate demand curve would shift left by the amount

of increase in G, but it actually shifts– sorry not left, right. I swear I do know the difference

between my left and my right. So it would actually

increase not by 96, but by 384. So that’s the overall idea

of the multiplier effect. Now, one thing to notice

is the Multiplier Effect doesn’t just apply to changes

in government spending. It applies to any change in spending out there

in the economy. So in particular, let’s suppose that we

have a real estate market crash and we have a decrease in residential construction

spending of $360 billion, how much does aggregate

demand decrease? Well, it doesn’t decrease

by just $360 billion because when there’s $360 billion

less construction spending, a bunch of income is lost

for construction workers and building suppliers

and so on and so forth, and then they spend less, and then that lowers the income

for people who, you know, would have sold them,

you know, sweat socks and so on

and so forth out there, and then that lowers someone

else’s income, and so on and so

forth out there. So a high multiplier means aggregate demand is very

sensitive to changes in spending. A low multiplier means aggregate

demand is insensitive. So often when students first see

discussion of the multiplier, they think oh,

a high multiplier is good. Because that means

with a relatively small amount of change of spending, the government can move

aggregate demand but a lot, so that’s going to go ahead

and be a good thing, it’ll be easy

to use fiscal policy to get aggregate demand

where we want. But it’s also true

that a high multiplier means aggregate demand is very

unstable. You know, we sort of say

if someone’s sensitive, someone’s a very

sensitive personality, that can be kind of a double

edged compliment, right? It can mean

that they’re very perceptive, or it can mean that they’re sort

of emotionally unstable. A low multiplier means an

aggregate demand is insensitive, or we could also say

it’s very stable. Now,

what does the multiplier actually look

like in our economy? The simply multiplier I gave

earlier is too simple. A more realistic multiplier would take account of at least

two additional facts. So first, not

all increases in income are available to spend. Because, say for instance,

people pay taxes. So when you

have a higher income, not all of that $64

billion is available for you to spend because you

pay taxes on that income. Second, what we would

see here is some income is spent on imports, so it kind of leaks

out of the system. So let’s go ahead and call

little t is our tax rate, as a decimal. So that is, we’re going

to think say for instance, maybe in the United States, the average tax rate is 0.025,

so 25% on average. And let’s think about what call our Marginal Propensity

to Import, which is the idea of if you have

one dollar of extra spending, how much of that is spent

on imports? And let’s call that 10%. So if we do all that,

our formula for the multiplier, our more realistic formula

for the multiplier ends up being a kind

of ugly fraction, one minus our

Marginal Propensity to Consume times one

minus our tax rate t plus our Marginal Propensity

to Import M, and if you plug these in with

a sort of real world estimate of what the Marginal Propensity

to Consume in the U.S. is, which is about 85%, then

a more realistic multiplier for the U.S. is somewhere

around 2.16. And even this is sort of

probably a best case scenario, because there’s

some other things that are more complicated

to go into here, but this is probably a max

possible multiplier for U.S. So roughly speaking, if we increase government

spending by one dollar, well, we increase aggregate

demand by one dollar times 2.16. So of that one

dollar was an increase in government spending and 1.16

is going to be an increase in consumption spending.

Im so confused. Where did 64 come from? I get 72 when I mulitpy 96 x 3/4