Hello everyone, this video introduces you to third macroeconomic relationship that is between aggregate spending in the economy and change in the overall output in the economy. When economy has potential to expand, increase in spending leads to increase in real GDP. That's what we call multiplier effect. Shows how an initial change in spending can flow through the system to generate much larger effect in the real GDP.

So multiplier is a factor by which initial change in spending basically magnifies. So we can calculate multiplier as change in real GDP over change in initial spending. So actually, if you look at this value, this has to be greater than one. That means if a dollar is spent in the economy, we expect that to have much bigger effect. on the GDP.

Why is that true? Every time you spend a dollar in the economy, that goes as an income to someone else. That someone else is going to spend in the economy and that cycle moves on. That will create a much more bigger effect on overall GDP.

Now, to understand this one, okay, so that is going to depend. In service-driven economy, increase in spending will lead to increase in income for others. That person will increase income expected.

to spend part of that money and that cycle actually continues. What does that depend on? That actually depends on marginal propensity to consume which is MPC.

That means what fraction of the income or what percentage of income you're actually going to spend in the economy. So multiplier another way of showing is 1 over 1 minus MPC. That means when MPC increases 1 minus MPC decreases that means multiplier is actually going to be much bigger.

So as MPC increases, multiplier effect also increases. To see this one, we want to take a simple example. Suppose if an economy has marginal propensity to consume or MPC to be 0.75.

The spending in the economy increases by 100. Calculate the change in real GDP. So I am actually going to use two formulas. First one I'm looking at marginal propensity to consume converting into multipliers.

So that's going to be 1 over 1 minus 0.75 which is 1 over 0.25 that's going to be 4. So that means every dollar spent in the economy will have 4 times the effect. If you see multiplier, so what do we know here? Multiplier I already calculated which is 4. Initial change in the spending.

which is basically 100 so what am i looking at what is the change in real gdp so change in real gdp is going to be 100 times 4 that is 400 if it is in billion so obviously this is going to be in billions so at marginal propensity to consume to be 0.75 the overall effect of 100 billion increase in spending in this economy is going to be 400 billion change in the real GDP.