Multipliers & Fiscal Policy MPC, MPS & Multiplier Analysis AD2 ----------------- Y2

GDP Leakage Leakage to GDP: S + T + M Injections to GDP: I + G + X Leakages - Income not passed on by consumers in the circular flow GDP = Y = C + I + G + (X – M) Leakage to GDP: S + T + M (S = Savings T= taxes M = Imports) Injections to GDP: I + G + X (Investment, Gov’t, Exports) In equilibrium: Leakage = Injections

Multipliers & Fiscal Policy Fiscal Policy has a multiplier affect on AD If G↑ 1 billion => Real GDP ↑ by more than 1 billion! Size of MPC/MPS determines how far AD shifts Larger the MPC => the bigger the shift in AD! In the short run => consumption more powerful than savings savings is considered leakage from GDP BUT, Savings eventually turns into Investment

3 Fiscal Policy Multipliers Gov’t Spending & Investment Multiplier Tax Multiplier Balanced Budget Multiplier = 1/MPS = -MPC/MPS = 1 Multipliers tell you how far AD shifts? You can calculate ↑ R-GDP from Y1 to Y2 AD2 ----------------- Y2

Gov’t Spending & Investment Multiplier Multiplier = 1/MPS GDP will increases more than Gov’t spending rises Example: If MPC = .80 Multiplier => MPS = .20 1/.20 = 5 Example: If G ↑ $1 billion $1B X 5 = ↑ $5 billion RGDP

Multiplier & GDP Gov’t Spending & investment have “multiple” affect on GDP Government raises spending $100 PRODUCT Market If MPC = .80 FIRMS HOUSEHOLDS Change in GDP: Round 1 $100.0 Round 2 $80.0 Round 3 $64.0 Round 4 $51.2 Etc….. FACTOR Market Multiplier = 5 i.e. 1/MPS => 1/.20 = 5 So a $100 ↑ => causes Real GDP ↑ $500

Tax Multiplier Is always 1 less than Gov’t spending/investment multiplier Gov’t multiplier = 5 => tax multiplier = 4 TM = -MPC/MPS Example: $200 tax cut MPC = .80 Example: MPC = .80 Tax Multiplier => -.80/.20 = -4

Balanced Budget Multiplier Always equal to 1 (regardless of size of MPC) Example: Government ↑ Taxes & ↑ Spending by 1 billion Example: Spending Multiplier = 10 Tax Multiplier = -9 Always a difference of 1 G ↑ 1 billion = > Real GDP ↑ 10 billion Tax ↑ 1 billion => Real GDP ↓ 9 billion Net Effect: Real GDP ↑ 1 billion

Multipliers & Fiscal Policy Worksheet LRAS1 Price Level Real GDP SRAS1 AD1

Tax Cuts & MPC Group 1: MPC = .90 Group 2: MPC = .60 If taxes ↓ $1 billion, which GROUP would shift AD more? AD ↑ more with higher MPC Because, in short run, C↑ more BUT, in LONG RUN Savings turns into Investment So I is more powerful than C Raises full potential => LRAS ↑