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MPC, MPS, and Multipliers

MPC, MPS, and Multipliers. Special thanks to Mr. David Mayer & Mr. Ken Norman from whom I adapted this power point. The Multiplier Effect. The Multiplier Effect. The Multiplier Effect.

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MPC, MPS, and Multipliers

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  1. MPC, MPS, and Multipliers Special thanks to Mr. David Mayer & Mr. Ken Norman from whom I adapted this power point

  2. The Multiplier Effect The Multiplier Effect The Multiplier Effect • 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.

  3. The Multiplier Effect The Multiplier Effect The Multiplier Effect • 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.

  4. MPC 1/MPS = M .90 1/.10 = 10 .80 1/.20 = 5 .75 1/.25 = 4 .60 1/.40 = 2.5 .50 1/.50 = 2 Spending Multiplier = 1/MPS

  5. The First Round of Government Spending Causes The Biggest SplashMPC 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 Spending has already reached $462.50b Total Saving has reached $87.50

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

  7. Tax Multipliers Tax Multipliers Tax Multipliers • 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

  8. Tax Multiplier = -MPC/MPS MPC MPC/MPS = M .90 -MPC/.10 = -9 .80 -MPC/.20 = -4 .75 -MPC/.25 = -3 .60 -MPC/.40 = -1.5 .50 -MPC/.50 = -1

  9. Spending Multiplier = 1/MPS Tax Multiplier = MPC/MPS MPC Tax Multiplier Multiplier .910 -9 .85 -4 .754 -3 .602.5 -1.5 .52 -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

  10. 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.

  11. USING MULTIPLIERS • Since any change in GDP is the result of the change in spending x multiplier, you can find the multiplierbydividing the change in AD/GDP by the change in spending.

  12. USING MULTIPLIERS • Knowing that any change in spending will have a multiplied effect government can calculate how much to change spending bydividing the needed change in GDP by the multiplier.

  13. 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.

  14. 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

  15. 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.

  16. 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.

  17. 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

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