Fun!!! With the MPC, MPS, and Multipliers Special thanks to Mr. David Mayer & Mr. Ken Norman from whom I adapted this power point

Marginal Propensity to Consume (MPC) The fraction of any change in disposable income that is consumed. MPC= Change in Consumption Change in Disposable Income MPC = ΔC/ΔDI

Marginal Propensity to Save (MPS) The fraction of any change in disposable income that is saved. MPS= Change in Savings Change in Disposable Income MPS = ΔS/ΔDI

Marginal Propensities MPC + MPS = 1 .: MPC = 1 – MPS .: MPS = 1 – MPC Remember, people do two things with their disposable income, consume it or save it!

The Spending Multiplier Effect An initial change in spending (C, I, G, NX) causes a larger change in aggregate spending, or Aggregate Demand (AD).

The Spending Multiplier Effect Why does this happen? Expenditures and income flow continuously which sets off a spending increase in the economy.

The Spending Multiplier Effect Ex. If the government increases highway spending by $200 billion, then highway contractors will hire and pay more workers, which will increase aggregate spending by more than the original $200 billion.

Total Spending has already reached $462.50b The First Round of Government Spending Causes The Biggest Splash MPC of 75% G spends $200 billion on the highways. Highway workers save 25% of $200 billion [$50 billion] & spend 75% or $150 billion on boats. Boat makers save 25% of $150 bil. [$37.50 bil.] & spend 75% or $112.50 bil. on iPod Minis, etc. Total Spending has already reached $462.50b

Calculating the Spending Multiplier The Spending Multiplier can be calculated from the MPC or the MPS. Multiplier = 1/1-MPC or 1/MPS Multipliers are (+) when there is an increase in spending and (–) when there is a decrease

Expenditure Multiplier ME [Change in G, I, or NX] = 1/MPS MPC 1/MPS = M .90 1/.10 = 10 .80 1/.20 = 5 .75 1/.25 = 4 .60 1/.40 = 2.5 .50 1/.50 = 2 Expenditure Multiplier ME [Change in G, I, or NX] = 1/MPS

Calculating the Tax Multiplier When the government taxes, the multiplier works in reverse Why? Disposable income is decreased, meaning we spend less Tax Multiplier = MPC/1-MPC or MPC/MPS Its negative if taxes are increasing Its positive if taxes are decreasing

MT [Change in Taxes] = -MPC/MPS Tax Multiplier MT [Change in Taxes] = -MPC/MPS MPC MPC/MPS = M .90 -MPC/.10 = -9 .80 -MPC/.20 = -4 .75 -MPC/.25 = -3 .60 -MPC/.40 = -1.5 .50 -MPC/.50 = -1

ME = 1/MPS MT = MPC/MPS ME MT .9 10 -9 .8 5 -4 .75 4 -3 .60 2.5 .5 2 .9 10 -9 .8 5 -4 .75 4 -3 .60 2.5 -1.5 The larger the MPC, the smaller the MPS, and the greater the multiplier. .5 2 -1 The tax multiplier is always one less than the spending multiplier.

The Balanced Budget Multiplier in G = in T When Government Spending increases are matched with an equal size increase in taxes, that change ends up being = to the change in Government spending Why? Mathematically - 1/MPS + -MPC/MPS = 1- MPC/MPS = MPS/MPS = 1 Economically - Part of any tax change effects savings, meaning the change in spending due to the tax change is always less 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 MPS MPC = 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.