AP Macroeconomics

Fun!!! With the MPC, MPS, and

Multipliers

Disposable Income = DI

•Net Income

•Paycheck

•After-tax income

Marginal Propensity to Consume (MPC)

• The fraction of any change in disposable income that is consumed. New $ = new C

• 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.

• New $ = new savings• MPS= Change in Savings

Change in Disposable Income

• MPS = ΔS/ΔDI

Marginal Propensities

•MPC + MPS = 1 {i.e. every new $ is either spent (C) or saved.}– .: 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. New $ hits the circular flow….spending/earning/spending/earning….

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

EXAMPLE CALCULATIONS

• Business report states that in 2009, consumers spent only 80cents of each $, .: 1/1-mpc (1/1-.80) or 1/mps (1/.20) = ?

• Now calculate spending multiplier for mpc or .90; .75; .60; .50

Person MPC MPSFirst to get the new $

   

Second to use that $

   

Third to use that $    Fourth to use that $

   

Fifth to use that $    Total So Far of the Original $1000

   

Marginal Analysis: What happens when a new unit is added?MPC = What % of new DI will people ___________.MPS = What % of new DI will people ___________.MPC + MPS will always = ______.The Spending Multiplier EffectAssume new marginal income is created. Example: tax cut.Assume that the tax cut averages a new $1000 of disposable income.Assume that the current MPC will be 90% and the MPS will be 10%.Notice: For each person getting a new $1000, several consumption eventscan occur from that single amount of money. How long will the pattern continue? Economists use the Spending Multiplier Formula to estimate the number of times the pattern will repeat before the amount shrinks to a point where new spending stops. The formula is: 1/1-MPC, or 1/MPS.Therefore, if the MPC is .9, how many new dollars of consumption will be created if society receives $1 million dollars? ________.How many new dollars of consumption will be created if the MPC is only .5? ___________.

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

Tax multiplier calculations

• -mpc/1-mpc or –mpc/mps OR………

• Assume a tax hike of .90 to equal • -.90/10……..answer?• Now calculate other tax

multipliers with mpc of .80; .75; .60; .50

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

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.

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?

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 A change in T results in a change in Yd. Yd can be either spent (C) or saved (S); can be either spent (C) or saved (S);

therefore, a change in T only affects GDP therefore, a change in T only affects GDP by a multiple of the change in C. The by a multiple of the change in C. The

initial change in C is less than the change initial change in C is less than the change in T. in T.

No – G has a greater effect!

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:

T of $20 billion Yd _____ _____ C _____ S

_____ X ______ = ______

_____ X ______ = ______

Multiplier = _________ = _____1/1-.80 5

20 5 100 increase

20 16 4

16 5 80 increase which is less thanThe increase of 100 from G.

What would be the effect on the economy (GDP) of a decrease of $100

billion in G. Assume the MPS =.25

• What would be the effect of an increase in taxes of $100 billion?

100 X 4 = $400 billion decrease in GDP

Increase T of $100 billion decreases income (Yd) by100 billion. That means consumers will decrease spendingby $75 billion (.75 x100) and decrease saving by $25 bill.The $75 billion decrease in C X the multiplier of 4 = a $300Billion decrease in GDP.

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

5

Effect of G: 5 x 50 = 250 billion increase in GDPEffect 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 GDPNet effect: 250 – 200 = $50 billion increase in GDP

$40 billion(.80x50)

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

Multiplier Table

• Govt…..Invstmnt Spndng… Tax• MPC… .Multiplier…. Multiplier….

Multiplier• 0.90 10.0 10.0 –9.0• 0.80 5.0 5.0 –4.0• 0.75 4.0 4.0 –3.0• 0.60 2.5 2.5 –1.5• 0.50 2.0 2.0 –1.0

Key Formula: AE x M = GDP

• 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?

M = 1/MPS or 1/1-MPC or M = 1/MPS or 1/1-MPC or GDP/ GDP/ AEAE

AE x M = GDP

M = 1/1-MPC = 1/1-.80 = 1/.20 = _____M = 1/1-MPC = 1/1-.80 = 1/.20 = _____

______ X ______ = 100 Billion

5

20 5

Key Formula: AE x M = GDP

• If the GDP gap is $40 billion and the MPS = .25, what amount must AE increase to close the GDP gap?

M = 1/MPS or 1/1-MPC or M = 1/MPS or 1/1-MPC or GDP/ GDP/ AEAE

AE x M = GDP

M = 1/MPS = 1/.25 = _____M = 1/MPS = 1/.25 = _____

______ X ______ = 40 Billion

4

10 4

Key Formula: AE x M = GDP

• 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?

M = 1/MPS or 1/1-MPC or M = 1/MPS or 1/1-MPC or GDP/ GDP/ AEAE

AE x M = GDPM = 1/MPS = 1/.20 = _____M = 1/MPS = 1/.20 = _____

______ X ______ = 50 Billion

5

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?

A. Tax rates are decreased

B. Exports decreaseC. Imports decreaseD. Government

expenditures decrease

E. 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?A. Incomes will taxes

B. Incomes will C

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 MPC is 0.75, which of the following is true?

A. If income is $100, then saving is $75

B. If income is $100, then C is $50C. If income is $200, then saving is

$50D. If income is 200, then C is $75E. If income is $500, then S is $100

APC = fraction of income spent = .75 = 3/4ths

200 x .75 = $150 in consumption, leaving $50 in saving.

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?A. 420280

B. 600400C. 660320D. 660440E. 760340

C _ S

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?A. T by greater than $100 BB. T by $100BC. T by less than $100 B. T by $100 BE. 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 to a

change in GDP of 1000 to 1500, which of the following is

true?A. G is 300 and the multiplier is 5B. G is 100 and the multiplier is 5C. G is 100 and C increases by 500D. G and GDP increase by 500 eachE. C and GDP increase by 500 each

G = 100 GDP = 500 M = 5

AP M/C QUESTION

• An increase in the marginal increase in the marginal propensity to consumepropensity to consume causes an increase increase

• inin which of the following?• a. Marginal propensity to save• b. Spending multiplier• c. Saving rate• d. Exports• e. Aggregate supply

AC/DC MACROECONOMICS

• http://www.youtube.com/watch?v=Xg-0z5RWbAU

• http://www.youtube.com/watch?v=JQVfkH-2G-I

• http://education-portal.com/academy/lesson/the-multiplier-effect-and-the-simple-spending-multiplier-definition-and-examples.html#lesson