0:15
So, now that we've seen how fiscal policy could be
used, the question is, can we actually target that actual difference?
In other words, if we know that real GDP is, that, GDP as
we observe it is maybe 10 billion above where we'd like it to be.
Is there any way to focus in on that 10 billion and adjust government
spending or taxes just enough so that we get it where it suppose to be.
Well some people say that using economic policy is like shooting through
the fog at a moving target, with a weapon whose accuracy's uncertain.
Alright, it is sort of like that, but there are some
things that we can do to try to estimate exactly how
much fiscal policy we need, how much government spending or how
many tax cuts we need to, try to hit the target.
And there are times, actually, when it works quite well.
Other times, because the economy is such a
complex living organism, that it doesn't hit the target.
But anyways, we'll talk about the theory of how to hit that target.
1:21
And in order to do this, we need to define a few terms, alright.
One of these that we're going to define right now is the
marginal propensity to consume, propensity just means tendency, alright, so the
marginal propensity to consume or the MPC describes what a person
tends to do when you give them some more money, okay.
So, imagine that you have a rich uncle in Korea and
he sends you a $100 and you it, that comes shooting into
our income stream, doesn't it, from the outside, alright, and you receive
this money and you're going to decide what to do with it, right.
Now, what you do with it is a very interesting concept,
because it tends to be pretty stable in different societies over time.
You will have a tendency to consume a certain
amount, a certain percentage and then to save another percentage.
Now, we're talking about a small, closed economy with no government.
So, nobody's taxing you and you're not spending anything on imports.
All you can do with that money is you can consume it or you can save it, all right?
So, let's assume that you're in a country like the United States or like Spain and
you received that $100 and you immediately spend 90, all right?
The MPC is the change in consumption divided by the change in income.
So, your change in income was 100 and your change in consumption
was 90, the percent that you spent out of that new income was 90%.
So our MPC is 90% or 0.9, okay.
Now, what we'd like to know, in order to
understand government policy, is if we shoot this money in,
now we've got a Korean uncle shooting it in
at this point, but later on it'll be the government.
I shoot this money into the circular flow of the
economy, eventually how much will GDP go up as a result?
3:19
Now, the fact is that often GDP will go up by more than that initial injection.
By how much more?
Well, we need to know that so that we can get the amount right.
And the way we can find it out is using the multiplier.
The formula for the multiplier is 1 divided by 1 minus the MPC,
alright, which we've just defined or it could also be 1 divided by the MPS.
That marginal propensity to save is a percentage of
money that you saved when you got that $100, okay?
If you spent 90, you saved 10, all right?
So you can see these two will add up to one.
All right?
So, 0.9 and 0.1 add up to 1.
So, 1 divided by 1 minus the MPC, in the case we were just talking about,
where the MPC is 0.9, 1 divided by 0.1 gives us a multiplier of 10.
What does that tell us?
Well, it tells us that whatever income get shot into the economy, into the circular
flow, will magnify itself 10 times as we go around the economy.
Let me just show you how this works.
We've got an Excel sheet where these calculations
are, and you can see, why that initial
$100 will turn into 10 times the $100,
or 1,000, as it circulates around the economy.
Just have a look here.
You can see, here we've got the $100 going into
the economy, up, in, the left hand, upper left hand cell.
It's actually b2, alright, where the $100 goes in.
You can see, in the next column, the MPC, which is 0.9, okay?
So that means the $100 that I receive, I spend 90, alright,
and then you can see the MPS in the next column, it's 0.1.
0.9 plus 0.1 add up to 1, which is what has to happen.
That means I save $10, okay?
So, the total impact on GDP is 90.
Alright.
Now, that 90 goes into somebody else's pocket, and somebody
else says, oh good, I've got 90 in new income.
I'm going to spend 0.9 of 90, and I'm going to save 0.1 of 90.
So here we go to the second row, you see the person receiving in round two, $90.
They spend 81 of it and they save nine, so this lifts
again the spending in the economy by 81 and induces 81 in new output.
And that 81 goes into a new pocket or a new wallet.
That person then will take that 81 and they'll say good, I've got new income.
I'm going to spend 0.9 of it, just like everybody else does in this economy.
That means they spend 72.9, they save 8.1,
and again, output income are lifted by 72.9.
If we repeat this over and over, and you can see as you look at this Excel.
I carry it out actually to 60 rounds until the, the increase almost disappears.
If we repeat this over and over and we go down, we can see
how much GDP will go up as a result of that initial injection of $100.
And, if you add them all up, you see that it's about $1,000.
Now, the shortcut, rather than doing all these
rounds, is to say, $100 went into the economy.
My multiplier is ten, GDP will rise by 100 times 10, 1,000.
Okay?
Now, we can do the same calculation, you can see there is
another tab on this Excel where the MPC is smaller, it's 0.5.
So, this is a more saving economy, when the Korean uncle sends that $100, people
only spend 50, and they squirrel away 50 in their savings account, okay?
So, if that happens, we have an MPC of 0.5,
and MPS of 0.5, of course they add up to 1.
We take our multiplier formula, 1 divided by, 1 minus the MPC.
Or, 1 divided by the MPS in different.
And we're going to get actually, instead of ten that
we got last time, we're just going to get two.
7:27
What this tells us, and you can see it
on the Excel, is that $100 goes into the economy.
And goes around in the different rounds, but it's exhausted much faster.
And when we add up how much it raised GDP, it's only 200.
Okay, the calculation, the, the quicker calculation would be
to say, 100 comes in the multiplier is two2,
100 times 2 tells us the increase in GDP,
we're going to get as a result of this initial injection.
Now, this also works in the opposite direction, okay?
So, if your Korean uncle needed you to lend him $100.
Alright.
$100 would leave the economy and it would
then have a magnified shrinking affect on the economy.
Okay.
Here we've seen a magnified expansive effect.
I put in $100, it becomes 200 or it becomes 1,000.
If I take out $100, it would also reduce
GDP by a multiple of itself, using the multiplier.
Okay, so minus 100 times 10 in the first case means GDP
would fall by 1,000 as a result of these 100 leaving the economy.
In the second case minus 100 times 2.
GDP would fall by 200 as a result of this money leaving the economy.
The way we can illustrate this on
our aggregate supply aggregate demand diagram that
we've been working with is just to show that you've got aggregate demand here.
And let's say, the government spending program is $20 billion.
So aggregate demand shifts out to the right in that first round.
But eventually, as all of these rounds make their way through
the economy, the impact on the economy will be much bigger.
So, we're going to get an aggregate demand three, as you see here
in this picture, which is shifted out by much more than that initial impulse.
The same thing would happen in the inward direction
if we pulled government spending out of the economy.
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Gayle AllardProfessor
