Multipliers & Fiscal Policy MPC, MPS & Multiplier Analysis

MPC & MPS Importance Size of MPC/MPS determines how far AD shifts Fiscal Policy has a multiple affect on AD If G↑ 1 billion => Real GDP ↑ by more than 1 billion! LRAS1 Price Level Real GDP SRAS1 AD1

Gov’t Spending/Investment Multiplier Multiplier = ∆GDP / ∆ Gov’t Spending GDP increases more than Gov’t spending rises 2-ways to calculate multiplier: (you need to know MPC or MPS) 1/(1-MPC) or 1/MPS Example: If MPC = .80 1/(1-.80) = 5 or 1/.20 = 5

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

The Tax Multiplier Multiplier = ∆GDP / ∆ Taxes Is always smaller by 1 than spending/investment multiplier spending multiplier = 5 => then tax multiplier = 4 TM = -MPC/MPS or -MPC x (spending multiplier) Example: $200 tax cut MPC = .80 Example: MPC = .80 1/(1-.80) = 5 TM = -.80 * 5 = -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