The Multiplier Effect- Macro Topic 3.2
[STARTS AT 0:49]
MR. CLIFFORD: Let's start with the spending multiplier. When the government spends money, it becomes somebody's income, and they save a portion of that, and they spend the rest. That spending becomes somebody else's income, and they save some and spend some. That keeps happening over and over again, and that's called the multiplier effect.
An initial change in spending causes a ripple effect for the entire economy, and leads to more total spending. The size of that ripple effect depends on how much people spend, or save, when they get new income. That's called the marginal propensity to consume, and the marginal propensity to save.
For example let's say you find $100 in the ground, and you spend $75 and save $25. Your MPC is 0.75, and your MPS is 0.25. Together they have to equal one, because only two things you can do with new income, spend it or save it. Which reminds me, in exam questions we often assume that everyone in the economy has the same propensity to consume, and save. Which isn't really true in real life, but that's OK.
The equation for this simple spending multiplier is one over the marginal propensity to save. So if the MPC is 0.5, then the MPS is 0.5, then the spending multiplier is 1 over 0.5. Which is just 2. So if the government increases spending by $2 billion, that will eventually become $4 billion of total spending.
Did you get that? [GARBLED] Of the equation for this simple spending multiplier is 1 over the marginal propensity to save. So if the MPC is 0.5, then the MPS is 0.5, then the spending multiplier is 1 over 0.5. Which is just 2. So if the government increases spending by $2 billion, that will eventually become $4 billion of total spending.
Now it's your turn. Let's say the MPC is 0.9, and the government looks to increase total spending by $20 billion two questions? How much is a simple spending multiplier, and how much initial government spending must be done to achieve the $20 billion of total spending? Hello? Hello, are you on? Hello, are you working? Are you working, yes, yes?
OK, so if the MPC is 0.9, then the MPS must be 0.1. That means that the multiplier is 1 over 0.1, or 10. And if the goal is to spend a total of $20 billion, then the government only needs to spend $2 billion. That $2 billion times a multiplier of 10 becomes $20 billion.
Notice that in both of these examples, the initial change in spending was $2 billion, but one led to $4 billion of total spending, and the other one had $20 billion in spending. The reason for the difference was the amount that people consumed, or spent of new money coming in. The point is, the higher MPC, larger the multiplier effect.
[ENDS AT 3:14]