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Multipliers & Fiscal Policy

Multipliers & Fiscal Policy. MPC, MPS & Multiplier Analysis. MPC = .60. MPC + MPS = 1. MPC + MPS = 1. Group 1: MPC = .90 Group 2: MPC = .60 If taxes were reduced , which MPC would shift AD more?. AD ↑ more with higher MPC Because, in short run, C↑ more.

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Multipliers & Fiscal Policy

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  1. Multipliers & Fiscal Policy MPC, MPS & Multiplier Analysis

  2. MPC = .60 MPC + MPS = 1 • MPC + MPS = 1 Group 1: MPC = .90 Group 2: MPC = .60 If taxes were reduced, which MPC would shift AD more? AD ↑ more with higher MPC Because, in short run, C↑ more MPS = .40

  3. Multipliers & Fiscal Policy • Fiscal Policy has a multiplier affect on AD • If G↑ 1 billion => Real GDP ↑ by more than 1 billion! • Size of MPC/MPS determines how far AD shifts • Larger the MPC => the bigger the shift!

  4. Gov’t Spending & Investment Multiplier • Multiplier = ∆GDP / ∆ Gov’t Spending • GDP increases more than Gov’t spending rises • 2-ways to calculate multiplier: (you need to know MPC or MPS) 1/(1-MPC)or1/MPS Example:IfMPC = .80 1/(1-.80) = 5 or 1/.20 = 5

  5. Multiplier & GDP • Gov’t Spending & investment have “multiple” affect on GDP Government raises spending $100 PRODUCT Market If MPC = .80 FIRMS HOUSEHOLDS Change in GDP: Round 1 $100.0 Round 2 $80.0 Round 3 $64.0 Round 4 $51.2 Etc….. FACTOR Market Multiplier = 5 i.e. 1/MPS => 1/.20 = 5 So a $100 ↑ => causes Real GDP ↑ $500

  6. The Tax Multiplier • Multiplier = ∆GDP / ∆ Taxes • Is always smaller by 1 than spending/investment multiplier • spending multiplier = 5 => then tax multiplier = 4 • TM = -MPC/MPS or -MPC x (spending multiplier) • Example: $200 tax cut MPC = .80 Example:MPC = .80 1/(1-.80) = 5 TM = -.80 * 5 = -4

  7. Balanced Budget Multiplier • Always equal to 1(regardless of size of MPC) • Example:Government ↑ Taxes & ↑ Spending by 1 billion Example: Spending Multiplier = 10 Tax Multiplier = 9 Always a difference of 1 G ↑ 1 billion = > Real GDP ↑ 10 billion Tax ↑ 1 billion => Real GDP ↓ 9 billion Net Effect: Real GDP ↑ 1 billion

  8. LRAS1 Price Level SRAS1 Real GDP AD1 Multipliers & Fiscal Policy Worksheet

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