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AP Macroeconomics

AP Macroeconomics. MPC, MPS, and Multipliers. “We are what we repeatedly do. Excellence, then, is not an act but a habit.” ~ Aristotle. Disposable Income. Net Income Paycheck After-tax income. The Spending Multiplier Effect.

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AP Macroeconomics

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  1. AP Macroeconomics MPC, MPS, and Multipliers

  2. “We are what we repeatedly do. Excellence, then, is not an act but a habit.” ~ Aristotle

  3. Disposable Income • Net Income • Paycheck • After-tax income

  4. The Spending Multiplier Effect • An initial change in spending (C, IG, G, XN) causes a larger change in aggregate spending, or Aggregate Demand (AD).

  5. The Spending Multiplier Effect • Why does this happen? • Expenditures and income flow continuously which sets off a spending increase in the economy.

  6. MPC & MPS • Marginal Propensity to Consume • % of every extra dollar earned that is spent • ΔC/ΔDI • Marginal Propensity to Save • % of every extra dollar earned that is saved • ΔS/ΔDI • MPC + MPS = 1

  7. Marginal Propensities • MPC + MPS = 1 • .: MPC = 1 – MPS • .: MPS = 1 – MPC • Remember, people do two things with their disposable income, consume it or save it!

  8. 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.

  9. Calculating the Spending Multiplier • The Spending Multiplier can be calculated from the MPC or the MPS. • Multiplier = 1/MPS OR 1/1-MPC • Change in GDP=change in spending*multiplier

  10. Putting it all together • Ex. Assume U.S. citizens spend 90¢ for every extra $1 of disposable income 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 Spending Multiplier to use. • Either 1/MPS OR 1/1-MPC • Step 3: Calculate the Spending Multiplier • 1/MPS = 1/.10 = 10 OR 1/1-MPC=1/1-.9=10 • Step 4: Calculate the Change in AD • (Δ C, IG, G, or XN) * Spending Multiplier • ($50 billion Δ IG) * (10) = $500 billion ΔAD

  11. MPS, MPC, & Multipliers • Historically speaking, the Japanese are big savers. Let’s say that for every extra dollar of disposable income they earn they spend 25 cents. If they were each given a stimulus check by how much would aggregate demand change assuming the total stimulus was three billion dollars? • Step 1: Calculate the MPC and MPS • MPC = ΔC/ΔDI = .25/1= .25 • MPS = 1 – MPC = 1-.25=.75 • Step 2: Determine which multiplier to use. • Either 1/MPS OR 1/1-MPC • Step 3: Calculate the Spending Multiplier • 1/MPS = 1/.75= 1.333OR 1/1-MPC=1/1-.25=1.333 • Step 4: Calculate the Change in AD • (Δ C, IG, G, or XN) * Spending Multiplier • ($3 billion Δ DI) * (1.333) = $3.999 billion ΔAD

  12. Calculating the Spending Multiplier • 1/MPS or 1/1-MPC • The smaller the fraction of any change in income saved, the greater the respending at each round and, therefore, the greater the multiplier. • The larger the fraction of any change in income spent, the greater the respending at each round and, therefore the, the greater the multiplier.

  13. MPC & MPSReview and Summary • Marginal Propensity to Consume • ΔC/ΔDI • % of every extra dollar earned that is spent • Marginal Propensity to Save • ΔS/ΔDI • % of every extra dollar earned that is saved • MPC + MPS = 1 • 1 – MPC = MPS • 1 – MPS = MPC

  14. MPC & MPSReview and Summary • Multipliers (two to chose from) • 1/1-MPC • 1/MPS

  15. “Failure is simply the opportunity to begin again, this time more intelligently.” ~ Henry Ford

  16. Calculating the Tax Multiplier • When the government increases taxes, the multiplier works in reverse • Why? • Because now money is leaving the circular flow • Tax Multiplier (note: it’s negative if taxes 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

  17. 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

  18. Change in G vs. Change in T • A change in government transfers or taxes shifts the aggregate demand curve by LESS than an equal-sized change in G. Why? • Because the transfer payment itself does not count as an increase in G. We have to spend some of the money to see any change on AD. However a change in G itself immediately changes AD. • People will save at least a portion of their transfer.

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