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The Multiplier

The Multiplier. AP Macro Unit 2 Class Notes and Several helpful unit 2 videos have been uploaded to class website. The Multiplier. Consumption is the largest component of AD. Q: What determines a person’s level of consumption?

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The Multiplier

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  1. The Multiplier AP Macro Unit 2 Class Notes and Several helpful unit 2 videos have been uploaded to class website

  2. The Multiplier • Consumption is the largest component of AD. • Q: What determines a person’s level of consumption? • Disposable Income (DI): Amount of money that consumers have available for spending & saving after income taxes. • APC (Average Propensity to Consume): Proportion of income that a person spends. • APC = C/DI • APS (Average Propensity to Save): Proportion of Income that a person saves. • APS = S/DI • C + S = DI and therefore APC + APS = 1. • “Investment” Update! • Economics always focuses on marginal analysis (changes or additions)

  3. Marginal Propensity to Consume (MPC) • Additional spending that results when a consumer receives additional DI. • MPC= Change in Consumption_____ Change in Disposable Income • MPC = ΔC/ΔDI

  4. Marginal Propensity to Save (MPS) • Additional saving that results when a consumer receives additional DI. • MPS = Change in Savings_________ Change in Disposable Income • MPS = ΔS/ΔDI

  5. Marginal Propensities • Because DI = S + C, then… • MPC + MPS = 1 • What does all of this mean? • Example 

  6. The Spending Multiplier Effect • An initial change in spending (C, I, G, XN) causes a larger change in aggregate spending, or Aggregate Demand (AD)!!! • Any initial change in spending will be multiplied!

  7. Calculating the Spending Multiplier • Spending Multiplier = 1/1-MPC or 1/MPS • How and when to use the spending multiplier: Δ inGDP = Δ in AD component x spending multiplier

  8. Calculating the Tax Multiplier • A change in taxes will affect spending because it affects disposable income. • Tax multiplier is – with tax increase and + with tax cut. • A change in taxes must change DI before it changes spending (different from a change in C,I,G,Xn) • Tax Multiplier (note: it’s negative for tax increase) • = -MPC/1-MPCor -MPC/MPS

  9. Practice #1 • 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 I 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

  10. Practice #2 • Assume the USraises taxes on its citizens by $200 billion . Furthermore, assume that Americans save 25% of the change in their disposable income. Calculate the effect the $200 billion change in taxes has on the American 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 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

  11. Practice #3 • Assume Americansspend 4/5 of their disposable income. Furthermore, assume that the American 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 American 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

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