14.2 - 'The multiplier model'. The purpose of this model is to show how an initial change in
the spending side of the economy, in the demand side of the economy, can get amplified. Let's say:
how a reduction in spending in the economy can push the economy into a vicious circle of lower
spending, lower production, lower spending lower production. But what's the reason
behind this vicious circle? To understand that, let's just go back to the circular flow model.
Here's that model. This model shows us that someone's spending is another person's income.
Let's say for whatever reasons -you know households panic and they start to reduce their
spending, then the firms will cut down their production and fire their workers. If firms
fire their workers this means the households will have less money to spend and if they spend
less the firms have to cut down their production. So you see the logic behind this vicious circle.
Now let's go back to the multiplier model and show this process through a graph.
So we go back and start to scroll down...
...and here's our model. The x-axis has the total output
in the economy and the y-axis is total spending - total aggregate demand,
and this line - the 45-degrees line represents the case where the spending is equal the total output.
In other words, there is no shortage or excess of demand in the economy. Now we want to model the
spending side and show how changes in the spending side can impact the output. The first component of
total spending is consumption and the consumption itself has two components. The first component of
it is autonomous consumption: this is the amount that we spend that is not dependent of our current
income. If our current income goes to zero, we're going to spend this amount anyway. Maybe
our household has a lot of savings, maybe our household has access to credit. So we're going to
spend this amount anyway. We call that 'autonomous consumption'. The second component of consumption
is the variable consumption and that depends on our current income and if our current income goes
up, we're going to spend a fraction of that, and we call that 'marginal propensity to consume'.
Now, the higher our marginal propensity to consume, it means this line will be steeper;
the lower the marginal propensity to consume, this line would be flatter: this means that
our consumption is less reliant on our current income. We are doing more consumption smoothing.
So, so far, we modelled total consumption in our economy and that's represented by this line.
Now we need to add another component to our spending and that's investment and here
we are thinking of this investment as autonomous - as independent
of the total output and income in our economy. So we represent investment by this distance.
Now this line represents the total aggregate demand - the total spending in our economy.
The next step we want to show you is how an initial change in aggregate demand
can push the economy into a vicious circle. So let's scroll down.
Here's the exact multiplier model that we discussed above and A represents the equilibrium.
Why? Because the aggregate demand is equal to aggregate output at point A. In order to better
understand why this is an equilibrium, let's think of a situation when the economy is not in an
equilibrium. Let's think of point B. There we have excess demand in our economy: people are rushing
to shops to buy goods, firms are running out of stocks, queues are forming outside of shops,
and in this situation firms can respond in two ways: they can either increase their prices,
or as depicted in this graph, increase their output and hire more workers.
Also, we can think about the opposite case, for instance: the economy experiences a shortage of
demand and in response the firms can either reduce their prices, or reduce the outputs to get back to
point A. So, I gave you an idea why point A is an equilibrium. Now I want to explain to you how
an initial drop in aggregate demand can push the economy into a vicious circle of lower spending
and lower output. So let's start. Now, let's assume for whatever reason our firms panic and
they decide to cut down on their investment, so the demand for investment drops by 1.5
billion. This represents a shortage of demand in our economy and in response the firms that
are producing investment machineries, investment goods, cut down on their output by 1.5 billion.
Therefore the income also goes down 1.5 billion. Now, it's important to mention that
here we are assuming that firms are not decreasing their prices in response to the drop in demand.
In response, they are decreasing their production - their output. So, to summarise, we had a fall
in the investment demand by 1.5 billion and this fall translated to a fall of output by
1.5 billion. This is the first round of effects, but the story does not stop here. Now,
the second round. As income drops, consumption also drops, why? Because, as you remember, part
of your consumption depends on your current income and if your current income falls by 1.5 billion,
the consumption should drop but by a fraction of 1.5 billion. So the drop in consumption would be
to a lesser degree. Here our economy again faces a shortage of demand shortage for consumer goods.
In response, the firms cut down on their output, fire workers, income falls,
as income falls the consumption should also fall. So you have a vicious circle until you reach
to a new equilibrium which is represented by point Z here. Here, your economy finally stabilises at
a situation where you have a much lower level of aggregate spending and output. So you see,
the multiplier model tells us: an initial drop in 1.5 billion of investment demand has
kick-started rounds of negative effects, rounds of reduction in spending and output until our economy
reaches to a new equilibrium. This model shows us that the initial drop by 1.5 billion has
translated to a much bigger drop in output - a drop of 3.75 billion,
and here we get the size of multiplier. The multiplier is the drop in output - 3.75 billion,
divided by the fall in spending - 1.5 billion. We get 2.5
in the end. Let me go through the assumptions that this model is making. The first assumption is that
firms respond to any changes in the aggregate demand by adjusting their output instead of
adjusting their prices. So we are assuming that prices are fixed. The second assumption is that
some of the households are credit constrained: they cannot fall back on their past well so
they can't access credit from the banks, therefore they're not able to smooth out their consumption.
Of course there are some households that are able to smooth out their consumption, so the model is
not saying that there is complete smoothing of consumption, or complete lack of access to credit.
The model is saying that on the aggregate level, the economy is made of different households: some
of them are able to smooth out their consumption - we put them in the autonomous consumption,
some of them are not able to smooth out their consumption - they're credit constrained.
And finally this model assumes that there is no government and the economy is closed. The
aggregate demand is made of only two components: consumption and investment. Now, in the end,
let me talk about the solution. So, what happens if an economy experiences an initial drop in
aggregate demand? What's the solution. What's the appropriate policy for the government to follow,
to make sure that the economy does not follow into a vicious circle of lower spending, lower output?
Now, the government can come up with two series of policies: the first one is fiscal
policy - it could boost the spending in the economy. The government can become
the spender of last resort - or it could lower taxes for the households and firms.
The other policy is monetary policy: it can lower the nominal interest rates and boost
the aggregate demand. Both of these policies are aimed at changing the aggregate demand
and you're going to read more of them in the subsequent sections. Thank you.