MPC, MPS, and Multipliers AP Macroeconomics MPC, MPS, and Multipliers

“We are what we repeatedly do “We are what we repeatedly do. Excellence, then, is not an act but a habit.” ~ Aristotle

Disposable Income Net Income Paycheck After-tax income

The Spending Multiplier Effect An initial change in spending (C, IG, G, XN) causes a larger change in aggregate spending, or Aggregate Demand (AD). We are going to calculate the total change in GDP given a change in C, Ig, G, and/or Xn

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

AVERAGE Propensity to Consume/Save The APC and APS is the percentage of disposable income that is consumed and saved There are only two things you can do with DI. Save or consume it. Given that the Japanese are big savers. Do they have a low or high APC? Given that Americans are big consumers do we have a low or high APS?

MPC & MPS Marginal Propensity to Consume Marginal Propensity to Save % of every extra dollar earned that is spent ΔC/ΔDI Marginal Propensity to Save % of every extra dollar earned that is saved ΔS/ΔDI MPC + MPS = 1 Because you can only save or consume. What you are NOT saving you are consuming What you are not consuming you are saving therefore MPC+MPS must equal 1 (100% of disposable income has been accounted for)

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 Ex. If the government increases defense spending by $1 Billion, then defense contractors will hire and pay more workers, which will increase aggregate spending by more than the original $1 Billion.

Calculating the Spending Multiplier The Spending Multiplier can be calculated from the MPC or the MPS. Multiplier = 1/MPS OR 1/1-MPC Change in spending*multiplier=change in GDP Spending=changes in C, Ig, G, or Xn

Scenario You want to produce 50 apples by the end of October 2016. Each tree you plant will give you 5 apples. How many trees do you need to plant in the spring of 2014? Well, 50 divided by what will equal 5? That’s right, 10

Putting it all together Ex. Assume U.S. citizens spend 90¢ for every extra $1 of disposable income they earn. Further assume that the real interest rate (r%) decreases, causing a $50 billion increase in gross private investment. Calculate the effect of a $50 billion increase in IG on U.S. Aggregate Demand (AD). Step 1: Calculate the MPC and MPS MPC = ΔC/ΔDI = .9/1 = .9 MPS = 1 – MPC = .10 Step 2: Determine which Spending Multiplier to use. Either 1/MPS OR 1/1-MPC Step 3: Calculate the Spending Multiplier 1/MPS = 1/.10 = 10 OR 1/1-MPC=1/1-.9=10 Step 4: Calculate the Change in AD (Δ C, IG, G, or XN) * Spending Multiplier ($50 billion Δ IG) * (10) = $500 billion ΔAD

MPS, MPC, & Multipliers Historically speaking, the Japanese are big savers. Let’s say that for every extra dollar of disposable income they earn they spend 25 cents. If they were each given a stimulus check by how much would aggregate demand change assuming the total stimulus was three billion dollars? Step 1: Calculate the MPC and MPS MPC = ΔC/ΔDI = .25/1 = .25 MPS = 1 – MPC = 1-.25=.75 Step 2: Determine which multiplier to use. Either 1/MPS OR 1/1-MPC Step 3: Calculate the Spending Multiplier 1/MPS = 1/.75 = 1.333 OR 1/1-MPC=1/1-.25=1.333 Step 4: Calculate the Change in AD (Δ C, IG, G, or XN) * Spending Multiplier ($3 billion Δ DI) * (1.333) = $3.999 billion ΔAD

Calculating the Spending Multiplier 1/MPS or 1/1-MPC The smaller the fraction of any change in income saved, the greater the respending at each round and, therefore, the greater the multiplier. The larger the fraction of any change in income spent, the greater the respending at each round and, therefore the, the greater the multiplier.

MPC & MPS Review and Summary Marginal Propensity to Consume ΔC/ΔDI % of every extra dollar earned that is spent Marginal Propensity to Save ΔS/ΔDI % of every extra dollar earned that is saved MPC + MPS = 1 1 – MPC = MPS 1 – MPS = MPC

MPC & MPS Review and Summary Multipliers (two to chose from) 1/1-MPC 1/MPS

“Failure is simply the opportunity to begin again, this time more intelligently.” ~ Henry Ford

Calculating the Tax Multiplier When the government increases taxes, the multiplier works in reverse Why? Because now money is leaving the circular flow Tax Multiplier (note: it’s negative if taxes increase) = -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

MPS, MPC, & Multipliers Ex. Assume Germany raises taxes on its citizens by €200 billion . Furthermore, assume that Germans save 25% of the change in their disposable income. Calculate the effect the €200 billion change in taxes on the German economy. Step 1: Calculate the MPC and MPS MPS = 25%(given in the problem) = .25 MPC = 1 – MPS = 1 - .25 = .75 Step 2: Determine which multiplier to use, and whether it’s + or - The problem mentions an increase in T .: use (-) tax multiplier Step 3: Calculate the Spending and/or Tax Multiplier -MPC/MPS = -.75/.25 = -3 Step 4: Calculate the Change in AD (Δ Tax) * Tax Multiplier (€200 billion Δ T) * (-3) = -€600 billion Δ in AD

Change in G vs. Change in T A change in government transfers or taxes shifts the aggregate demand curve by LESS than an equal-sized change in G. Why? Two reasons First, what are transfer payments? Unemployment compensation, Medicare, Medicaid Transfer payments do not count as G so it doesn’t count towards GDP

Change in G vs. Change in T Because the transfer payment itself does not count as an increase in G. We have to spend some of the money to see any change on AD. However a change in G itself immediately changes AD. People will save at least a portion of their transfer or tax cut.