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Published byAlyssa Malone Modified over 2 years ago

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Government spends £10 million on improving roads in Birmingham. ALL of this money goes into road builders pockets.

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MPC = 0.8; tax rate 25% They pay 25% in tax, leaving them £7.5 million in increased disposable income They save 20% (£1.5 million) leaving them to spend £6 million. They spend all of this £6 million on watching Birmingham City Football Club

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The Government spends £100 million on improving roads in Birmingham

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MPC = 0.8; tax rate 25% ALL of this £6 million goes to the football players (this is a very simplified example). THEY pay 25% in tax leaving them £4.5 million in increased disposable income They save 20% (£0.9 million) leaving them to spend £3.4 million. They spend all of this £6 million on watching the Birmingham Birmingham Royal BalletBirmingham Royal Ballet

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ALL of this goes to the dancers……………….. You can see that the initial injection of £10m led to a first round increase in consumers expenditure of £6m and a second round increase of £3m And so on and so on and so on………

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Sum the increases and they come to almost £25m.

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Tax Rate0.25 £ MillionsSavings Rate0.2 Government Injection10 1st round consumption6 2nd round consumption3.6 3rd round2.16 4th round th round th round th round th round TOTAL close to £25 million

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Tax Rate0.25 £ MillionsSavings Rate0.2 Government Injection10 1st round consumption6 2nd round consumption3.6 3rd round2.16 4th round th round th round th round th round TOTAL close to £25 million

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Hence the multiplier is 2.5= £25m/£10m. Can we prove this? Y=C+I+G (Closed economy) C=b0+b1*YD YD=(1-t)Y: t = tax rate C=b0+b1*(1-t)Y Y=b0+b1*(1-t)Y+I+G

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MPC=0.8; t=0.25 Y=b0+b1*(1-t)Y+I+G Y-b1*(1-t)Y=b0+I+G Y(1-b1*(1-t))=b0+I+G Y=[b0+I+G]/(1-b1*(1-t)) Any increase in G (or I, but b0 is fixed) will increase Y by 1/(1-b1*(1-t)) = 1/(1-0.8*(1-0.25)) = 1/(1-0.8*0.75) = 1/(1-0.6) =1/0.4 =2.5

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