Multiplier effect

The Keynesian multiplier

The Marginal Propensities As national income rises or falls, the level of consumption among households varies based on the marginal propensity to consume. Besides consuming with their incomes, households also save, pay taxes and buy imports. The proportion of any change in income that goes towards each of these is known as the marginal propensity 2.2 Aggregate Demand and Aggregate Supply Aggregate Demand

Calculating Marginal Propensities to Consume and Save Study the table below, which shows how consumption, taxes, savings and imports change following a $1 trillion increase in US households income. 2.2 Aggregate Demand and Aggregate Supply Assume US household income increases from $10 trillion to $11 trillion Income:ConsumptionTaxesSavingsImports $10 trillion$7 trillion$1.5 trillion$1 trillion$0.5 trillion $11 trillion$7.5 trillion$1.6 trillion$1.25 trillion$0.65 trillion Aggregate Demand

Calculating Marginal Propensities to Consume and Save Study the table below, then answer the questions that follow: 2.2 Aggregate Demand and Aggregate Supply Personal consumption ("personal outlays") and Personal savings in the US Source: / Aggregate Demand

2.2 Aggregate Demand and Aggregate Supply Aggregate Demand

The Spending Multiplier and Aggregate Demand The table below shows the changes in total spending that will result from an initial change in expenditures of $100 in an economy, based on different marginal propensities to consume. Study the data and then answer the questions that follow. 2.2 Aggregate Demand and Aggregate Supply Marginal Propensity to Consume Initial change in Expenditures (C, I, G or Xn) Size of the spending multiplier (1/1-MPC) Total change in spending in the economy What is the relationship between the MPC and the size of the spending multiplier? 2.What is a logical explanation for this relationship? 3.Under what circumstance will a particular increase in government spending be most effective, when the MPC is low or when it is high? 4.Does the multiplier effect work when the initial change in spending is negative? What would this mean for an economy in which business confidence is falling? Aggregate Demand

The Spending Multiplier and Aggregate Demand The effects of the spending multiplier can be seen on an aggregate demand curve. Assume, for example, an economy experiences $50 million increase in its net exports (perhaps due to a depreciation of its currency). The MPC in this economy is Aggregate Demand and Aggregate Supply Average Price level Real Gross Domestic Product (rGDP) AD1 The Aggregate Demand Curve AD2 Y1 Y2 Y3 P1 AD3 Aggregate Demand

2.2 Aggregate Demand and Aggregate Supply Aggregate Demand

The Tax Multiplier and Aggregate Demand If we know the MPC for a country, and we know how much taxes are cut by, we can calculate the tax multiplier and determine the ultimate change in total spending that will result from the tax cut. Remember that the MRL is always equal to 1-MPC. 2.2 Aggregate Demand and Aggregate Supply Marginal Propensity to Consume Initial change in Taxes Size of the tax multiplier (-MPC/MRL) Total change in spending in the economy Notice that at every level of MPC, the change in total spending that results from a $100 tax cut is LESS THAN the change in total spending that resulted from a $100 increase in spending (from an earlier slide). The tax multiplier will ALWAYS be smaller than the spending multiplier, a proportion of any tax cut will be leaked before it is spent. Aggregate Demand

Calculating the value of the multiplier The formal calculation for the value of the multiplier is Multiplier = 1 / (sum of the propensity to save + tax + import) Therefore if there is an initial injection of demand of say £400m and The marginal propensity to save = 0.2 The marginal rate of tax on income = 0.2 The marginal propensity to import goods and services is 0.3 Then the value of national income multiplier = (1/0.7) = 1.43 An initial change of demand of £400m might lead to a final rise in GDP of 1.43 x £400m = £572m If The marginal propensity to save = 0.1 The marginal rate of tax on income = 0.2 The marginal propensity to import goods and services is 0.2 The value of the multiplier = 1/0.5 = 2 – the same initial change in aggregate demand will lead to a bigger final change in the equilibrium level of national income.