﻿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.