Economics Ask the Instructor Clip 27 Transcript

Economics "Ask the Instructor" Clip 27 Transcript

What is the common sense explanation for the simple spending multiplier?

Let’s spend a few minutes on that because the multiplier concept and the formula for computing its size give a lot of students trouble.

The multiplier tells us that an increase in spending will, over time, result in an increase in GDP that is larger than the original expenditure. For example, an increase in business investment of, say, $1billion might cause GDP to rise by $2 billion. In this case the multiplier, the ratio of the change in GDP to the change in investment, would be 2.0.

To see how this might happen, let’s assume that you, some of your friends, and I contract to build a new facility for some business. It could be a warehouse, an office building, or in the case of a private college, a residence hall. Assume further that we provide all the inputs that go into the construction project. We own the timber, the steel mill, we provide all the labor, concrete, and insurance during construction. When the project is done, the business pays us for the construction, say $1million. How will this investment expenditure affect the economy? Well, according to the multiplier, it will cause the overall economy to increase by some multiple of $1 million.

And it’s easy to see why. When we collectively get paid the $1 million (remember, we created all the value represented by the investment expenditure and we therefore get paid the full $1 million) we will spend some part of it. How much? Well, that depends on our marginal propensity to consume, or MPC. Say we have an MPC of .5. This means that we spend $500,000 on goods and services, say haircuts, and then save the rest.

This means that barbers now have more customers than otherwise and their income increase by $500,000. The barbers in turn spend more than they would spend otherwise. How much more? Well, if we assume that they too have a marginal propensity to consume of .5, then they increase their consumption by $250,000. What do they buy? It could be anything. Let’s say they have their cars washed. The barbers’ increased consumer spending causes business at the car washes to increase and the car wash owners and their employees enjoy an increase in their incomes of $250,000.

We can already see that the effect on GDP resulting from the construction project is $1,750,000: the amount spent on the dorm we constructed plus the amount that we spent on haircuts, plus the amount the barbers spend on having their cars washed. Thus, the ratio of the change in GDP to the original investment outlay is $1,750,000 divided by $1,000,000, or 1.75.

But, clearly the multiplier process is not complete at this point. We would expect the owners and other people connected to the car wash business to go out and increase their spending by roughly $125,000, assuming they too have an MPC of .5. At this point the total increase in GDP traceable to the new residence hall is 1,875,000.

We could never trace all the GDP consequences of the original investment outlay even if we continued for the next hour, day, or lifetime for that matter! But we can use a formula, and that formula is- 1/(1-MPC) or 1/MPS (the marginal propensity to save) to see how big the multiplier actually is. You can see, the size of the multiplier varies directly with the size of society’s MPC.

There’s a lot more that could be said about the multiplier. But you now have the basic understanding of how it works. Later your instructor may add greater realism to the multiplier concept by incorporating taxation and imports.