MPC, MPS, and Multipliers

Special thanks to Mr. David Mayer & Mr. Ken Norman from whom I adapted this power point

• Any increase in spending will result in an even larger increase in GDP due to the fact that every dollar spent is spent again multiple times. • Any money spent is someone else’s income and therefore subject to spending.

• The limiting factor is savings. • For every additional dollar spent a portion of it will be saved (the MPS ). • The multiplier is the reciprocal of the MPS or

1/MPS.

• The larger the MPC (the smaller the MPS) the larger the multiplier will be.

Spending Multiplier = 1/MPS MPC 1/MPS .90

.80

.75

.60

.50

1/.10

1/.20

1/.25

1/.40

1/.50

= M = 10 = 5 = 4 = 2.5

= 2

The First Round of Government Spending Causes The Biggest Splash MPC of 75% G spends $ 200 billion on the highways .

Highway workers save 25% of $200 billion [$50 billion] & spend 75% or $150 billion on boats. Boat makers save 25% of $150 bil.

[$37.50 bil.] & spend 75% or $112.50 bil. on iPod Minis, etc.

Total Saving has reached $87.50

• A change in taxes also has a multiplied effect, but the tax multiplier is smaller than the spending multiplier.

• Tax Multiplier (note: it’s negative because tax increases reduce spending) 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 = MPC/MPS MPC .90

.80

.75

.60

.50

MPC/MPS = M -MPC/.10= -MPC/.20= -MPC/.25= -MPC/.50= -9 -4 -3 -MPC/.40= -1.5

-1

Spending Multiplier = 1/MPS MPC .9

.8

.75

Multiplier 10 5 -4 4 -3 Tax Multiplier = MPC/MPS Tax Multiplier -9 .60 2.5

-1.5

.5

2 -1

The

larger the MPC

, the

smaller the MPS

, and the

greater the multiplier

. This is the “simple multiplier” because it is based on a “simple model of the economy” .

OU

USING MULTIPLIERS

• The multiplier can be used to calculate how any change in spending will affect total spending (AD)/income (GDP). • The formula used is:

Change in Spending x Multiplier = Change in AD.

USING MULTIPLIERS

• Since any change in GDP is the result of the change in spending x multiplier, you can

find the multiplier by dividing the change in AD/GDP by the change in spending.

USING MULTIPLIERS

• Knowing that any change in spending will have a multiplied effect government can calculate how much to

change spending by dividing the needed change in GDP by the multiplier.

Multiplier Practice

• Assume US citizens spend $.90 for every extra $1 they earn. • Further assume that the real interest rate (i) decreases, causing a $50 billion increase in Investment (I). • Calculate the effect of this increase in spending on AD.

 Step 1: Calculate the MPC and MPS  MPC = C / DI  MPS = 1- MPC =  Step 2: Determine which multiplier to use, and whether its + or –  The problem mentions an increase in I, use a (+) spending multiplier  Step 3: Calculate the Spending and/or Tax Multiplier  Step 4: Calculate the Change in AD  ( C, I, G or NX) * Spending or Tax Multiplier

More Practice

• Assume Germany raises taxes on its citizens by 200b.

• Assume that Germans save 25% of the change in their disposable income. • Calculate the effect of these taxes on the German economy.

More Practice

• Assume the Japanese spend 4/5 of their disposable income.

• Assume that the Japanese government increases its spending by 50 trillion and in order to maintain a balanced budget simultaneously increase taxes by 50t.

• Calculate the effect of these changes on the Japanese Aggregate Demand.

The Balanced Budget Multiplier

• When government spending increases are matched with equal size increases in taxes, 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