 In this segment, we're going to talk about the investment multiplier. The investment multiplier is a very important concept, a somewhat difficult concept that lots of students have trouble with. The investment multiplier wasn't invented by or created by John Maynard Keynes, but it was used by John Maynard Keynes to help explain a number of things. The most important thing was, why is capitalism so volatile and unstable as it had been in the 20s and in the 30s when Keynes was writing about this? The second thing that the multiplier does is it helps explain why government intervention through fiscal policy, either the government spending money on projects like we have been doing recently since President Obama's fiscal stimulation. You can build roads and bridges and schools and whatever the government can do this helps stimulate the economy or it can cut taxes and if consumers or households spend the money from the tax cuts, which they may or may not do, that will help stimulate the economy. So it's important for both of these reasons. So the first question is, why is capitalism so volatile? So as you probably know or have talked about, in the 1920s the U.S. had this tremendous boom in which income grew and unemployment was low and labor productivity was high, financial markets were triumphant, everyone was making money on the stock market and then we had a financial crisis and the financial crisis helped drag down the real economy so that we entered by 1933, a really deeply depressed condition with GDP having fallen by almost a third and unemployment increased to 25 percent and then we stayed there for quite a while. So why does this happen? The culprit probably is in consumption spending because although consumption spending is very large, maybe two thirds on average in the modern economy of total GDP expenditures, it's not very volatile at least by itself. Generally speaking, consumption is not a fixed proportion of disposable income but a fairly fixed proportion of disposable income. Normally we're not going along in some situation and all of a sudden instead of spending two thirds of disposable income on consumption or 90 percent of disposable income on consumption, it changes a lot initiating a problem. But investment is volatile, in fact investment is potentially extraordinarily volatile. Why is this the case? Well think about it, when firms are making investment decisions, they're asking themselves, should I take ten million dollars of my own money or we borrow ten million dollars and build a new plant and is that a sensible thing to do? And the answer to that question says it all depends on how profitable the plant will be next year five years from now and ten years from now. So businesses should be stimulated to make investments when expected future profitability in the area they're investing is attracted. But how do we figure out what expected future profitability is going to be? How does a firm know now what the situation in its business line is going to be five years from now? And the answer is it doesn't. No one can tell it, there's no source of information. The future is unknowable or as Keynes stressed, the future is uncertain. So this means that business psychology becomes very important. So if the firm is optimistic and confident that the present is great and the future looks great, it'll invest a lot. If the firm is a little nervous about the current situation and thinks maybe the future situation isn't going to look so good, there's no reason at all it should invest. So business psychology which means that sometimes people get rose colored glasses and think the future looks terrific and everybody invests and sometimes it works the other way around and these can change depending on changes in the economy or changes in policy or changes in politics or whatever. This is also true about financial markets. Financial markets are notoriously unstable and are based on hopes and dreams which are optimistic sometimes and pessimistic sometimes. So there's a reason why investment is so unstable. But the problem or the challenge is investment is not two-thirds of GDP, investment may be 15% of GDP. So how do you get something like the Great Depression in which GDP falls by a third from, let's say, a third collapse in investment spending? Well, it doesn't seem obvious. I mean, if investment spending collapses by a third and investment's only 15% of GDP, then GDP maybe will collapse by 5%. Here's where the multiplier comes in. What happens if things look bad and businesses decide to invest less? They stop ordering. They cut down on their orders for the production of equipment. So if they cut down on their production of equipment, then the firms that generally sell this equipment will have to see their orders go down and will have to lay off workers. When they lay off their workers, those workers now don't have jobs and income, so they can't spend money. So they stop buying cars. So when they stop buying cars, the auto industry has to lay off workers in the car industry. Now they don't have income and they can't buy houses. So now we have a layoffs in the housing industry. So because investment affects household income and household income then affects consumption, we can get a kind of a mutually interacting dynamic that can pull us up in the good times or pull us way down in the bad times. So what's the relationship in the end between how much, if investment falls by a dollar, how much will GDP fall by? Cancel it was about two and a half times. That is if investment fell by a dollar, eventually GDP would fall by two and a half dollars. So this helps explain why investment, which is not a large percent of GDP but it's volatile, can cause a large decline in GDP. Now, there's a good side of this or a flip side of this. Suppose the economy is stagnating, it's in a deep recession. All right, the government can spend money to help move the economy out of recession, but the government may not be a huge spender either. The larger the spender, the easier it is to do it. So what if the government spends a dollar? Well, here the process works in reverse. So if the government spends a dollar, let's say it buys, it pays someone to build a road, then that someone has to buy workers to build the pay, someone has to hire and pay workers to build that road. The workers then have new income and they can buy new cars. The car industry will hire more workers and they can buy new houses and it works in the opposite direction. So the bad news is that investment is volatile and has a powerful impact on GDP. The good news is that the government can intervene to partially compensate for investment volatility or if the economy is in a rather bad situation, it can intervene and the power of the money it spends is greater than the expenditures. So that makes fiscal policy powerful.