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.