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Learn the toughest concepts covered in your Macroeconomics class with step-by-step video tutorials and practice problems.

Fiscal Policy

Government Purchases and the Multiplier Effect


Government Purchases GDP Multiplier

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Now let's see how the multiplier effect comes into play when we have a change in government spending. So we're dealing with fiscal policy and we have the government changing its amount of spending, increasing its spending or decreasing its spending, it's gonna have a chain reaction throughout the economy. So the multiplier effect, this describes this chain reaction. First, there's gonna be an initial boost in government spending which leads to a much higher increase in GDP. Now it can go the other way to a decrease in government spending can lead to a much higher decrease in GDP. For the same reason this multiplier effect. Okay, now I want to make a note, you've probably heard of the multiplier effect before and if you haven't, that's okay, the multiplier effect affects all the parts of G. D. P. So we remember GDP we have C. Plus I plus G plus N. X. Well, any of these three, a change in investment, government spending or not exports, It's gonna have a multiplier effect on consumption. Okay, that's how this multiplier effect works. It affects consumption in multiples most of the time when you when you talk about the multiplier effect, it's dealing with either an increase in investment spending or an increase in government spending, like we're gonna discuss here. So let's go ahead and kind of play it out. Let's see how it works. First. The government's going to increase their spending which in turn increases the income of households. How does that happen? Well the government say they start a new construction project, they decide to refurbish the highways and bridges of the country. Well, they're gonna need to hire people, right? They're gonna hire construction workers to fix the highways and that's more income going to households right there, creating jobs, that's increasing income. So when these these households have increased income, Well, guess what? It's going to lead to higher household consumption when they're making more money, they're gonna spend a little more on consumption. And you can refer to the marginal propensity to consume. We talk about that in another video, that's the idea for every more income. When you have more income, you're gonna save some and spend some, consume more, I'll say consume some, save some. So the marginal propensity to consume, deals with how much of that extra income goes towards consumption. Okay, So after that increased consumption. Well, that increased consumption is going to create another wave of consumption and there's gonna be even more consumption based on that additional consumption. So more and more consumption. And it's gonna keep going based on that marginal propensity to consume. Okay, so let's let's imagine this example here, government land has increased government spending by $5 billion. So this initial $5 billion. Well, it's gonna increase consumer spending. So let's imagine that those $5 billion dollars that the government spent was all earned by households. Okay. And let's say that households have a marginal propensity to consume Of .75. So that means for every dollar that they earn. They're gonna spend 75 cents of that dollar. Okay, so let's get out of calculator and let's make this assumption right here. So Let's say the marginal propensity to consume is 75. That means this $5 billion 75% of it is going to be spent in the second round right here. So that means of the $5 billion $5 billion. And then those households went out and spent $3.75 billion 3.75 billion and that 3.75 billion that was spent. Well, it was earned by somebody and they're gonna spend 75% of it. Right? So you can imagine that this 3.75 is now going to go through another round of multiplier effect here And it's about 2.8 billion Um in the next round. So times .75 again is about 2.1 billion in the next round. And this keeps happening notice it keeps getting smaller, but this all in some leads to a lot more uh spending than just the initial five billion right? There was initially five billion spent by the government. But it led to this chain reaction of extra spending based on people earning money and spending it and earning money and spending it. Right? So this initial boost in spending has this multiplier effect. So how does this affect aggregate demand? Well remember here I'm gonna move this over here. So right here we had a government purchases increasing and then consumption increasing consumption increasing consumption increasing. Right? These are all parts of our GDP equation, parts of our aggregate demand. So as this happens what what what we see on our aggregate demand graph is remember this is price level and this is G. D. P. Over here. So if we were initially if we were initially at this point what we would first have one shift to the right from the government spending. So we'll say uh from g right that first initial spending and then it's gonna boost again. Maybe a little smaller boost. Okay and this will be from the first round of consumption and then another boost maybe even smaller. And this is C. two, right? It's it's keeps boosting to the right based on these this additional spending. Right? So the multiplier effect really tells us that we don't just get this one boost from uh from government purchases, There's multiple boosts going on here, right? It's not just the one boost to the aggregate demand, there's additional shifts that happened from this multiplier effect. So when it all rounds out what what actually happens with the multiplier effect? Well this is our equation right here, remember that multiplier was all based on that marginal propensity to consume when the consumers when the households got this extra money based on the government spending. Well they didn't spend all of it. So depending on how much of it they're willing to spend is how big the multiplier is going to be. You can imagine the more that the households are willing to spend, there's gonna be a bigger multiplier effect because there's more and more spending going on. So this right here is how we calculate our multiplier, 1/1 minus M. P. C. Is the multiplier? Okay so sometimes on a test they'll just ask you what is the multiplier in this situation And for our situation we'd go one divided by one minus 10.75 Which equals one over .25 which is four. So in our case the multiplier was four meaning the initial spending of the government, The initial spending the government spent five will the total change in GDP would be five times 4 multiplier right there Which is 20. So when when the marginal propensity to consume that MPC is .75. Well, an initial change of spending of five by the government actually affects GDP by an increase of 20. Okay so that's quite a big increase. So you can see that fiscal policy can have a multiplier effect in the sense that maybe just by increasing spending a little, there can be a great change in the economy. Okay so there we go. That's the multiplier effect. Be familiar with this equation. 1/1 minus MPC. They love to test on that. Alright, let's go ahead and move on to the next video.