Fun!!! With the MPC, MPS, and Multipliers AP Macroeconomics Fun!!! With the MPC, MPS, and Multipliers

Disposable Income Net Income Paycheck After-tax income

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 Why does this happen? Expenditures and income flow continuously which sets off a spending increase in the economy. Read pg. 199

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 = 1/1-MPC or 1/MPS Multipliers are (+) when there is an increase in spending and (–) when there is a decrease

Calculating the Tax Multiplier When the government taxes, the multiplier works in reverse Why? Because now money is leaving the circular flow Tax Multiplier (note: it’s negative) = -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 U.S. citizens spend 90¢ for every extra $1 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) or AE. Step 1: Calculate the MPC and MPS MPC = ΔC/ΔDI = .9/1 = .9 MPS = 1 – MPC = .10 Step 2: Determine which multiplier to use, and whether it’s + or - The problem mentions an increase in Δ IG .: use a (+) spending multiplier Step 3: Calculate the Spending and/or Tax Multiplier 1/MPS = 1/.10 = 10 Step 4: Calculate the Change in AD/AE (Δ C, IG, G, or XN) * Spending Multiplier ($50 billion Δ IG) * (10) = $500 billion ΔAD/AE

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/AE

MPS, MPC, & Multipliers Ex. Assume the Japanese spend 4/5 of their disposable income. Furthermore, assume that the Japanese government increases its spending by ¥50 trillion and in order to maintain a balanced budget simultaneously increases taxes by ¥50 trillion. Calculate the effect the ¥50 trillion change in government spending and ¥50 trillion change in taxes on Japanese Aggregate Demand or AE. Step 1: Calculate the MPC and MPS MPC = 4/5 (given in the problem) = .80 MPS = 1 – MPC = 1 - .80 = .20 Step 2: Determine which multiplier to use, and whether it’s + or - The problem mentions an increase in G and an increase in T .: combine a (+) spending with a (–) tax multiplier Step 3: Calculate the Spending and Tax Multipliers Spending Multiplier = 1/MPS = 1/.20 = 5 Tax Multiplier = -MPC/MPS = -.80/.20 = -4 Step 4: Calculate the Change in AD [ Δ G * Spending Multiplier] + [ Δ T * Tax Multiplier] [(¥50 trillion Δ G) * 5] + [(¥50 trillion Δ T) * -4] [ ¥250 trillion ] + [ - ¥200 trillion ] = ¥50 trillion Δ AD/AE

The Balanced Budget Multiplier That last problem was a pain, wasn’t it? Remember when Government Spending increases are matched with an equal size increase in taxes, that 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

Does a change in G have the same effect on GDP as a change in T? No – G has a greater effect! A change in G affects GDP directly by a multiple of the change in G. A change in T affects GDP by a multiple of less than the change in T. A change in T results in a change in Yd. Yd can be either spent (C) or saved (S); therefore, a change in T only affects GDP by a multiple of the change in C. The initial change in C is less than the change in T.

Effect of the the increase in G: Determine the effect on GDP of an increase in G of $20 billion and the effect of a decrease in T of $20 billion. Assume the MPC = .80 Effect of the the increase in G: Effect of the decrease in T: 1/1-.80 5 Multiplier = _________ = _____ 20 5 100 increase _____ X ______ = ______ 20 16 4  T of $20 billion   Yd _____   _____ C _____ S 16 5 80 increase which is less than The increase of 100 from G. _____ X ______ = ______

What would be the effect of an increase in taxes of $100 billion? What would be the effect on the economy (GDP) of a decrease of $100 billion in G. Assume the MPS =.25 100 X 4 = $400 billion decrease in GDP What would be the effect of an increase in taxes of $100 billion? Increase T of $100 billion decreases income (Yd) by 100 billion. That means consumers will decrease spending by $75 billion (.75 x100) and decrease saving by $25 bill. The $75 billion decrease in C X the multiplier of 4 = a $300 Billion decrease in GDP.

Effect on GDP (economy)? Increase by $50 billion Determine the effect on GDP of equal increases (balanced budget) in both G and T of $50 billion. Assume an MPC of .80. Effect on Budget? Effect on GDP (economy)? Increase by $50 billion Multiplier = _____  C = _____ balanced $40 billion (.80x50) 5 Effect of G: 5 x 50 = 250 billion increase in GDP Effect of T: decrease income by $50 billion; therefore, C decreases by $40 billion and S decreases by $10 billion. Therefore, $40 billion X 5 = 200 billion decrease in GDP Net effect: 250 – 200 = $50 billion increase in GDP

Key Idea: The balanced budget multiplier is 1 x G An increase in G and T of $50 billion would increase GDP by how much? ________ A decrease in G and T of $30 billion would decrease GDP by how much? _______ Conclusion: A balanced budget increase in G and T (spending and taxes are equal) has an ____________ effect on the economy. A balanced budget decrease in spending and taxes has an ______________ effect on the budget. 50 billion $30 billion expansionary contractionary

Spending Multiplier Formulas: M = 1/MPS or 1/1-MPC or GDP/ AE .80 5 If the MPS = .20 the MPC = ____ M = ____ If the MPC = .75 the MPS = ____ M = ____ If the MPC = .90 the MPS = ____ M = ____ If the change in GDP = $20 billion and the change in AE = $5 billion, then the multiplier = ____ and the MPC = _____ and the MPS = _____. .25 4 .10 10 .75 4 .25

Key Formula:  AE x M =  GDP M = 1/MPS or 1/1-MPC or GDP/ AE If the GDP gap is $100 billion, how much must AE (C, I, G, or Xn) increase to return the economy to YF if the MPC = .80? 5 M = 1/1-MPC = 1/1-.80 = 1/.20 = _____  AE x M =  GDP 20 5 ______ X ______ = 100 Billion

Key Formula:  AE x M =  GDP M = 1/MPS or 1/1-MPC or GDP/ AE If the GDP gap is $40 billion and the MPS = .25, what amount must AE increase to close the GDP gap? 4 M = 1/MPS = 1/.25 = _____  AE x M =  GDP ______ X ______ = 40 Billion 10 4

Key Formula:  AE x M =  GDP M = 1/MPS or 1/1-MPC or GDP/ AE If the economy is in a recession and has a GDP gap of $50 billion, how much must government increase G to close the GDP gap and return to full employment, assuming an MPS of .20? 5 M = 1/MPS = 1/.20 = _____  AE x M =  GDP ______ X ______ = 50 Billion 10 5

If $500 billion in AE  $1000 billion in GDP, then how much would G have to  to reach a YF of $2000 billion? $2000B $1000B $500B $200B $100B Explanation: 1000/500 = 2 = Multiplier = GDP/AE AE x Multiplier = GDP G x 2 = 2000 G = 1000

The value of the spending multiplier decreases when? Tax rates are decreased Exports decrease Imports decrease Government expenditures decrease The MPS increases The multiplier = 1/MPS 1/.20 = 5 1/.40 = 2.5 As MPS increases, the multiplier decreases.

Which of the following best explains why equilibrium income will rise by more than $100 in response to a $100 increase in G? Incomes will    taxes Incomes will   C AE  PL D. AE  MS   I E. budget deficit  AE Multiplier effect – Spending becomes Income which is either Spent or saved; the New expenditure gives rise to more income, which leads to more spending.. . .

In a closed economy with no taxes in which the APC is 0 In a closed economy with no taxes in which the APC is 0.75, which of the following is true? APC = fraction of income spent = .75 = 3/4ths If income is $100, then saving is $75 If income is $100, then C is $50 If income is $200, then saving is $50 If income is 200, then C is $75 If income is $500, then S is $100 200 x .75 = $150 in consumption, leaving $50 in saving.

Suppose that Yd is $1000, C is $700, and the MPC is 0. 60 Suppose that Yd is $1000, C is $700, and the MPC is 0.60. If Yd increases by $100, C and S will equal which of the following? C _ S 420 280 600 400 660 320 660 440 760 340 YD = 1000 C = 700 S = 300 as a starting point Yd = 100 and MPC = .60 C = .60 (100) = 60 and  S = .40 (100) = 40 700 + 60 = 760 C 300 + 40 = 340 S

If at YF, government wants to increase its spending by $100 billion without inflation in the short run, it must do which of the following?  T by greater than $100 B  T by $100B  T by less than $100 B  T by $100 B  by less than $100 B G has a greater effect on GDP than T; there- fore the  T must be Greater than the  G to offset the increased G and prevent further Inflation.

If AE  from 200 to 300 solely due to a change in G leads which leads to a change in GDP of 1000 to 1500, which of the following is true? G = 100 GDP = 500 M = 5 G is 300 and the multiplier is 5 G is 100 and the multiplier is 5 G is 100 and C increases by 500 G and GDP increase by 500 each C and GDP increase by 500 each