Copyright © 2004 South-Western Multipliers of all kinds The general idea of a multiplier A factor of proportionality that measures how much one variable changes in response to a change in some other variable The types of multipliers: Spending multiplier Tax multiplier Money multiplier We will deal with Spending and Tax multipliers now—will deal with Money multiplier later

Copyright © 2004 South-Western Yd = C + S Marginal Propensity to Consume (MPC) MPC = ∆ Consumer Spending ∆ Disposable Income Marginal Propensity to Save (MPS) MPS = ∆ Saving ∆ Disposable Income MPC + MPS = 1 MPC = 1 - MPS MPS = 1 - MPC Looking Behind the Spending and Saving Multiplier

Copyright © 2004 South-Western Government Spending Multiplier Government purchases are said to have a multiplier effect on aggregate demand. Each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar. Spending multiplier (M) = 1/(1-MPC)

Copyright © 2004 South-Western Government Spending Multiplier Spending multiplier (M) = 1/(1-MPC) Example : Suppose the government is experiencing a recessionary gap. Current output is $500 billion below potential GDP. Does the government need to inject $500 billion of new G into the economy to return to full employment? No!!! If MPC=.90, the spending multiplier will be M = 1/.10 = 10 So an increase of G=$50 billion will eventually multiply to a 10*$50 billion = $500 billion shift of AD to the right.

The Spending Multiplier Effect Quantity of Output Price Level 0 Aggregate demand,AD 1 $50 billion AD 2 AD 3 1. An increase in government purchases of $50 billion initially increases aggregate demand by $50 billion but the multiplier effect can amplify the shift in aggregate demand. Copyright © 2004 South-Western $450 billion

Copyright © 2004 South-Western Tax Multiplier Tax Policy also has a multiplier effect on aggregate demand. Each dollar of taxes raised, or lowered by the government can raise or lower the AD for goods and services by more than a dollar. However… the Tax Multiplier effect is < Spending Multiplier effect WHY??? Consumers will save some of every new dollar of Yd. If $$ of new Yd are saved, those $$ cannot multiply into additional spending and income.

Copyright © 2004 South-Western Tax Multiplier Effect Tm = MPC * M=1/1-MPC Example : Suppose the government decides to lower income taxes by a lump-sum $1000. The MPC =.90. When Americans get $1000 back into their pockets, they will save $100 (10%) and spend $900 (90%). $900 of new spending will now multiply by a factor of 10 because M=1/.90 = 10. So $1000 tax cut will eventually multiply into $9000 of additional real GDP.

Copyright © 2004 South-Western Tax Multiplier Effect Tm = MPC * M=1/1-MPC Another Example: Suppose the government decides to increase transfer payments by a lump-sum of $500. The MPC =.80 When Americans receive $500 more disposable income, they will save $100 (20%) and spend $400 (80%). $400 of new spending will now multiply by a factor of 5 because M = 1/.80 = 5. So a $500 increase of transfers will eventually multiply into $2000 of additional real GDP.

Copyright © 2004 South-Western The Tax Multiplier Effect Quantity of Output Price Level 0 Aggregate demand,AD 1 $50 billion AD 2 AD 3 A tax break of $50 billion initially increases aggregate demand by $50 billion but the multiplier effect can amplify the shift in aggregate demand. Copyright © 2004 South-Western $100 billion