Macro Chapter 8 Presentation 1- Marginal Propensities and the Multiplier

Income, Consumption, and Savings In general, as income goes up, people spend more---Direct relationship People also tend to save more as income increases Savings = Disposable Income - Consumption

45-Degree Line A reference line used to compare consumption and savings Consumption = DI If you assume that the reference line is DI, then the vertical distance between the 45 degree line and a given consumption line will tell you the amount of savings

Income and Consumption Consumption (billions of dollars) Disposable Income (billions of dollars) Consumption and Disposable Income, ° Reference Line C=DI Consumption In 1992 Saving In ° C

Dissaving Spending more on consumption than your after- tax income

Break-Even Income The level of disposable income at which households will spend all DI and have zero savings

Average Propensity to Consume (APC) the fraction or % of income that is consumed APC = Consumption Income

Average Propensity to Save (APS) The fraction or % of income that is saved APS = Saving Income

Average Propensities Contd. Since DI is either consumed or saved…. APC + APS = 1 Ex- if APS is.04, APC must be.96

Marginal Propensity to Consume (MPC) The fraction that is spent from a change in DI Ex- If income increases from 470B to 490B, and consumption increases from 435B to 450B MPC = ( )/ = 15/20 =.75 MPC = Change in Consumption Change in Income

Marginal Propensity to Save (MPS) Ex. If income increases from 470 B to 490B and Savings increases from 20B to 25B calculate MPS and MPC MPS = (25-20)/( ) = 5/20 =.25 *** MPS + MPC = 1 so MPC = =.75 MPS = Change in Saving Change in Income

The Multiplier Effect There is a direct relationship between changes in spending and real GDP ***A change in total spending leads to a larger change in GDP (multiplies) The money initially spent goes to profits, wages, rents etc. which are then spent in a chain reaction down the line

The Multiplier Effect Or Change in Real GDP = multiplier x initial change in spending Multiplier = Change in Real GDP Initial Change in Spending

Multiplier Effect and Marginal Propensities Multiplier = -or- Multiplier = MPC 1 MPS

Sample Problem The MPC is.8 and a business increases investment by $5 Billion. What is the multiplier? How much increase in GDP? Multiplier = 1/MPS or 1/1-MPC = 1/(1-.8) = 5 GDP = 5 x 5 = 25 Billion increase

The Multiplier Effect (1) Change in Income (2) Change in Consumption (MPC =.75) (3) Change in Saving (MPS =.25) Increase in investment of $5 Second Round Third Round Fourth Round Fifth Round All other rounds Total $ $ $ $ $ $ 5.00 Rounds of Spending 12345All $ $5.00 $3.75 $2.81 $2.11 $1.58 $4.75 ΔI= $5 billion

The MPC and the Multiplier MPCMultiplier