• Any increase in spending will result in an even larger increase in GDP due to the fact that every dollar spent is spent again multiple times.
• Any money spent is someone else’s income and therefore subject to spending.
Decisions to Save and Spend
• How strong the multiplier effect will be is determined by our decisions to save and spend.
• As our income changes we will spend a portion and save a portion of this change.
Marginal Propensity to Marginal Propensity to ConsumeConsume
• The portion we spend is known as our Marginal Propensity to Consume (MPC)
• It is found by dividing the change in Consumption by the change in Disposable Income
• For example if we receive a $10 an hour raise and we spend $9 of it and save $1, then our MPC is .9
C / DI = MPC so 9/10 = .9
Marginal Propensity to SaveMarginal Propensity to Save• The portion we save is known as our
Marginal Propensity to Save (MPS)
• It is found by dividing the change in Savings by the change in Disposable Income
• For example if we receive a $10 an hour raise and we spend $9 of it and save $1, then our MPS is .1
S / DI = MPS so 1/10 = .1
• The MPC + MPS is always equal to 1
• The limiting factor for the multiplier effect is savings.
• For every additional dollar spent a portion of it will be saved (the MPS).
• The multiplier is the reciprocal of the MPS or 1/MPS or 1/1- MPC.
• The larger the MPC (the smaller the MPS) the larger the multiplier will be.
MPC MPC 1/MPS 1/MPS = = M M.90.90 1/.101/.10 = = 1010.80.80 1/.201/.20 = 5= 5.75.75 1/.251/.25 = 4= 4.60.60 1/.401/.40 = 2.5= 2.5.50.50 1/.501/.50 = 2= 2
Spending MultiplierSpending Multiplier = = 1/MPS1/MPS
The First Round of The First Round of GovernmentGovernment Spending Causes The Biggest Spending Causes The Biggest SplashSplash MPC of 75%MPC of 75%G spends $G spends $200200 billion on the billion on the highwayshighways..Highway workers save 25% of $200 Highway workers save 25% of $200 billion billion [$50 [$50
billion] & spend 75% or $150 billion on boats. billion] & spend 75% or $150 billion on boats.
Boat makers save 25% of $150 Boat makers save 25% of $150 bil.bil. [$37.50 bil.] [$37.50 bil.] & & spend 75% or $112.50 bil. on iPod Minis, etc.spend 75% or $112.50 bil. on iPod Minis, etc.
Total Saving has reached $87.50
• The multiplier can be used to calculate how any change in spending will change total spending (AD) or income (GDP).
• The formula used is: Change in Spending x Multiplier = Change in AD/GDP.
• Ex: G $1b x 4 = $4b in AD/GDP
USING MULTIPLIERS
USING MULTIPLIERS
• Since any change in GDP is the result of the change in spending x multiplier, you can find the multiplier by dividing the change in AD/GDP by the change in spending.
• Ex: $4b AD/GDP / $1b in G =
multiplier of 4
USING MULTIPLIERS
• Knowing that any change in spending will have a multiplied effect government can calculate how much to change spending by dividing the needed change in GDP by the multiplier.
• Ex: GDP is $4b below full employment
$4b needed / 4 = $1b in G
• A change in taxes also has a multiplied effect, but the tax multiplier is smaller than the spending multiplier.
• Tax Multiplier (note: it’s negative because tax increases reduce spending)
-MPC/1-MPC or -MPC/MPS
• If there is a tax-CUT, then the multiplier is +, because there is now more money in the circular flow
MPCMPC MPC/MPSMPC/MPS = = M M.90.90 -MPC/.10-MPC/.10 = = -9 -9.80.80 -MPC/.20-MPC/.20 == -4 -4.75.75 -MPC/.25-MPC/.25 == -3 -3.60.60 -MPC/.40-MPC/.40 = = -1.5-1.5.50.50 -MPC/.50-MPC/.50 == -1 -1
Tax MultiplierTax Multiplier = - = -MPC/MPSMPC/MPS
Tax MultiplierTax Multiplier
-4-4
-3-3
-1.5-1.5
-1-1
-9-9
Tax Multiplier = -MPC/MPSTax Multiplier = -MPC/MPSSpending MultiplierSpending Multiplier = = 1/MPS1/MPS
MPCMPC MultiplierMultiplier
.9.9 1010
.8.8 55
.75.75 44
.60.60 2.52.5
.5.5 22The tax multiplier tax multiplier is always smallersmaller thanthan the spending multiplierspending multiplier because a portion of the change in income due to taxes is saved, reducing the overall impact on spending..
The Balanced Budget Multiplier
• When government spending increases are matched with equal size increases in taxes, the change ends up being = to the change in government spending
• Why?
• 1/MPS + -MPC/MPS = 1- MPC/MPS = MPS/MPS = 1
• The balanced budget multiplier always = 1
Multiplier Practice
• Assume US citizens spend $.90 for every extra $1 they earn.
• Further assume that the real interest rate (i) decreases, causing a $50 billion increase in Investment (I).
• Calculate the effect of this increase in spending on AD.
Step 1: Calculate the MPC and MPSMPC = C / DI MPS = 1- MPC =
Step 2: Determine which multiplier to use, and whether its + or –The problem mentions an increase in I, use a (+)
spending multiplier
Step 3: Calculate the Spending and/or Tax Multiplier
Step 4: Calculate the Change in AD( C, I, G or NX) * Spending or Tax Multiplier
More Practice
• Assume Germany raises taxes on its citizens by 200b.
• Assume that Germans save 25% of the change in their disposable income.
• Calculate the effect of these taxes on the German economy.
More Practice
• Assume the Japanese spend 4/5 of their disposable income.
• Assume that the Japanese government increases its spending by 50 trillion and in order to maintain a balanced budget simultaneously increase taxes by 50t.
• Calculate the effect of these changes on the Japanese Aggregate Demand.