NAME: __________________________________________ DATE: ___________ PERIOD: _________
Multiplier Practice
1. Provide the formula for Marginal Propensity to Save: Change in saving / Change in Income
2. Explain MPS in your own words: The part of your extra income that you would save. If you gave me
$10, and I saved $2, my MPS is .2.
3. Provide the formula for Marginal Propensity to Consume Change in saving / Change in Income
4. Explain MPC in your own words: The part of your extra income that you would spend. If you gave me
$10, and I spent $8, my MPS is .8.
5. Provide the formula for the Spending Multiplier: 1 / MPS or 1 / (1-MPC)
6. Explain what the spending multiplier is in you own words:
The spending multiplier is a number that tells us how much of a change in AD would result from a given
change in spending.
1. Provide both formulas for the Tax Multiplier: -Spending Multipler-1
OR
- MPC/MPS
2. Why is the tax multiplier negative? There is an inverse (opposite) relationship between taxes and AD:
When taxes go DOWN aggregate demand goes UP.
3. Why is the tax multiplier less than the Spending Multiplier?
When the government spends money, they directly purchase something, which means there is already the full
amount of the change applied to AD. When they instead cut taxes, some of the change is saved, and therefore
the Multiplier Effect does not reach those saved dollars.
Answer the Following:
4. The government spends $3 Billion to buy police cars. Explain why AD might increase by more than $3
billion.
The government spends the money on police cars. The money is received by the car manufacturers, and
then a part of that money will be paid to suppliers, employees, etc. That money is income to them which
they’ll spend. So if the government spent 3 bil, and the car companies that received it spend 2.5 bil of that
money, for a total of 5.5 increase in AD. This process continues on and on.
5. Suppose economists observe that a 10 billion increase in government spending raises total demand by
$30 billion. What would the spending multiplier be under these circumstances? Show your work:
If a 10 billion increase in spending caused a 30 bil change in AD, we’d conclude the multiplier was 3:
Total Change = initial change x Ms
$30 bil = $10 bil x Ms
Ms = 3
6. Suppose government reduces taxes by $20 billion and that MPC is ¾.
a. What is the initial effect of the tax reduction on aggregate demand?
Increase of $15 billion…MPC = .75, therefore MPS = .25.
.25 x $20 billion = 5 billion saved.
When taxes are cut, MPS applies to the money not taxed away. Therefore, although the tax cut was
$20 billion, $5 billion was immediately saved.
b. What additional affects follow this initial effect? What is the total effect of the tax cut on AD?
To answer this simply and keep the confusion down, it’s easiest to start with the total change.
Change in AD = Initial Change x Multiplier
As you can see, the Tax Multiplier is not given, so we need to calculate it in order to solve.
Method 1:
Spending Multiplier = 1/(1-MPC) = 1/(1-.75) = 4
Tax Multiplier = -Spending Multiplier – 1 = -3
Method 2:
Tax Multiplier = -MPC/MPS = -.75/.25 = -3
Now that we have the Tax Multiplier, we can calculate the total change in AD:
Change in AD = Initial Change x Multiplier
Change in AD = -$20 Billion x -3
Change in AD = 60 billion
Final Answer:
The government reduced taxes by $20 billion. The initial effect on AD is an increase of $15 billion. This is
followed by a multiplier effect of $45 billion, for a total change in AD of $60 billion.