Multiplier
Macroeconomics
In Macroeconomics, it is
important to understand the
following relationships:
1.
2.
3.
4.
Disposable income and consumption
Disposable income and saving
The interest rate and investment
Changes in spending and changes in
real GDP
The Relationship Between
Income and Consumption
Disposable (after-tax) income equals
savings (S) plus consumption (C).
Economists define personal saving as “not
spending” or “that part of disposable
income not consumed.”
The Consumption Schedule or
“Consumption Function”
In the aggregate, households increase their
spending as their disposable income rises
and spend a larger proportion of a small
disposable income than of a large
disposable income.
Many factors determine the
nation’s levels of consumption
and saving, but the most
significant is disposable income.
The Saving Schedule or
“Saving Function”
There is a direct relationship between saving
and disposable income but saving is a smaller
proportion of a small DI than of a large DI.
Households consume a smaller and smaller
proportion of DI as DI increases; therefore,
they must be saving a larger and larger
proportion.
Dissaving (consuming in excess of
after-tax income) will occur at
relatively low DIs.
Households can consume more than
their incomes by liquidating (selling
for cash) accumulated wealth or by
borrowing.
Non income Determinants of
Consumption and Saving
(Other than disposable income, what else
effects consumption and saving?)
•
•
•
•
•
Wealth
Expectations
Real Interest Rates
Household Debt
Taxation
Changes in wealth, expectations, interest rates,
and household debt will shift consumption in one
direction and saving in the opposite direction.
In contrast, a change in taxes will result in
consumption and saving moving in the same
direction. A tax increase shifts both downward,
and a tax decrease shifts them upward.
Income minus taxes = Disposable Income
TM – 94
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© 2005 T h e M cG ra w -H ill C o m p an ies, In c. A ll R igh ts reserv ed .
Marginal Propensity to
Consume (MPC)
The proportion, or fraction, of any change in
income consumed is called the marginal
propensity to consume (MPC). The MPC is the
ratio of a change in consumption to a change in
the income that caused the consumption
change.
MPC = change in consumption
change in income
Marginal Propensity to Save
(MPS)
The fraction of any change in income
saved is the marginal propensity to save
(MPS). The MPS is the ratio of a change
in saving to the change in income that
brought it about:
MPS = change in saving
change in income
Marginal Propensities
• How much of every additional dollar in income is
consumed? MPC
• How much of every additional dollar iin income
is saved? MPS
• MPC + MPS = $1 of additional income
– .: MPC = 1 – MPS
– .: MPS = 1 – MPC
• Remember, people do two things with their
disposable income, consume it or save it!
THE SPENDING MULTIPLIER
(Sometimes called the
expenditures multiplier)
When C or Ig or G or Xn increases, real GDP also
increases.
But the total increase in real GDP is larger than the initial
increase in spending.
The multiplier is the amount by which a change in any
component of spending is magnified or multiplied to
determine the change that it generates in real GDP.
The Ripple Effect
• INTERACTIVE GRAPHIC: A look at how
one business closing changed the
spending habits of just one person OrlandoSentinel.com
The Multiplier Effect
A change in spending ultimately
changes output and income by more
than the initial change in investment
spending. This is called the multiplier
effect.
TM – 103
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© 2005 T h e M cG ra w -H ill C o m p an ies, In c. A ll R igh ts reserv ed .
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 in spending
• You multiply the multiplier times the
initial increase in spending to
determine total effect on real GDP.
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).
– 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
• (Δ C, IG, G, or XN) * Spending Multiplier
• ($50 billion Δ IG) * (10) = $500 billion ΔAD
Calculating the Tax Multiplier
• When the government increases or decreases
taxes, the multiplier is determined using a
different formula because tax increases or tax
decreases will change disposable income.
• Tax Multiplier (note: it’s negative if it is a tax
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
The Balanced Budget Multiplier
• When Government spending increases
are matched with an equal increase in
taxes (to balance the budget), the resulting
change in real GDP ends up being = to the
change in Government spending
• Why?
•
1/
-MPC/
1- MPC/
MPS/
+
=
=
MPS
MPS
MPS
MPS = 1
• The balanced budget multiplier always = 1
• 1 times the increase in Government
spending = Total impact on real GDP
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.
– 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
How Large is the Actual Multiplier Effect?
The Council of Economic Advisers, which
advises the U.S. President on economic
matters, has estimated that the actual
multiplier effect for the United States
is about 2.