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Fun!!! With the MPC, MPS, and Multipliers

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1 Fun!!! With the MPC, MPS, and Multipliers
AP Macroeconomics Fun!!! With the MPC, MPS, and Multipliers

2 Disposable Income Net Income Paycheck After-tax income

3 Marginal Propensity to Consume (MPC)
The fraction of any change in disposable income that is consumed. MPC= Change in Consumption Change in Disposable Income MPC = ΔC/ΔDI

4 Marginal Propensity to Save (MPS)
The fraction of any change in disposable income that is saved. MPS= Change in Savings Change in Disposable Income MPS = ΔS/ΔDI

5 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!

6 The Spending Multiplier Effect
Why does this happen? Expenditures and income flow continuously which sets off a spending increase in the economy. Read pg. 199

7 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.

8 Calculating the Spending Multiplier
The Spending Multiplier can be calculated from the MPC or the MPS. Multiplier = 1/1-MPC or 1/MPS Multipliers are (+) when there is an increase in spending and (–) when there is a decrease

9 Calculating the Tax Multiplier
When the government taxes, the multiplier works in reverse Why? Because now money is leaving the circular flow Tax Multiplier (note: it’s negative) = -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

10 MPS, MPC, & Multipliers Ex. 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 IG on U.S. Aggregate Demand (AD) or AE. 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/AE (Δ C, IG, G, or XN) * Spending Multiplier ($50 billion Δ IG) * (10) = $500 billion ΔAD/AE

11 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 = = .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/AE

12 MPS, MPC, & Multipliers Ex. Assume the Japanese spend 4/5 of their disposable income. Furthermore, assume that the Japanese 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 Japanese Aggregate Demand or AE. Step 1: Calculate the MPC and MPS MPC = 4/5 (given in the problem) = .80 MPS = 1 – MPC = = .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/AE

13 The Balanced Budget Multiplier
That last problem was a pain, wasn’t it? Remember when Government Spending increases are matched with an equal size increase in taxes, that the change ends up being = to the change in Government spending Why? 1/MPS + -MPC/MPS = 1- MPC/MPS = MPS/MPS = 1 The balanced budget multiplier always = 1

14 Does a change in G have the same effect on GDP as a change in T?
No – G has a greater effect! A change in G affects GDP directly by a multiple of the change in G. A change in T affects GDP by a multiple of less than the change in T. A change in T results in a change in Yd. Yd can be either spent (C) or saved (S); therefore, a change in T only affects GDP by a multiple of the change in C. The initial change in C is less than the change in T.

15 Effect of the the increase in G:
Determine the effect on GDP of an increase in G of $20 billion and the effect of a decrease in T of $20 billion. Assume the MPC = .80 Effect of the the increase in G: Effect of the decrease in T: 1/1-.80 5 Multiplier = _________ = _____ 20 5 100 increase _____ X ______ = ______ 20 16 4  T of $20 billion   Yd _____   _____ C _____ S 16 5 80 increase which is less than The increase of 100 from G. _____ X ______ = ______

16 What would be the effect of an increase in taxes of $100 billion?
What would be the effect on the economy (GDP) of a decrease of $100 billion in G. Assume the MPS =.25 100 X 4 = $400 billion decrease in GDP What would be the effect of an increase in taxes of $100 billion? Increase T of $100 billion decreases income (Yd) by 100 billion. That means consumers will decrease spending by $75 billion (.75 x100) and decrease saving by $25 bill. The $75 billion decrease in C X the multiplier of 4 = a $300 Billion decrease in GDP.

17 Effect on GDP (economy)? Increase by $50 billion
Determine the effect on GDP of equal increases (balanced budget) in both G and T of $50 billion. Assume an MPC of .80. Effect on Budget? Effect on GDP (economy)? Increase by $50 billion Multiplier = _____  C = _____ balanced $40 billion (.80x50) 5 Effect of G: 5 x 50 = 250 billion increase in GDP Effect of T: decrease income by $50 billion; therefore, C decreases by $40 billion and S decreases by $10 billion. Therefore, $40 billion X 5 = 200 billion decrease in GDP Net effect: 250 – 200 = $50 billion increase in GDP

18 Key Idea: The balanced budget multiplier is 1 x G
An increase in G and T of $50 billion would increase GDP by how much? ________ A decrease in G and T of $30 billion would decrease GDP by how much? _______ Conclusion: A balanced budget increase in G and T (spending and taxes are equal) has an ____________ effect on the economy. A balanced budget decrease in spending and taxes has an ______________ effect on the budget. 50 billion $30 billion expansionary contractionary

19 Spending Multiplier Formulas:
M = 1/MPS or 1/1-MPC or GDP/ AE .80 5 If the MPS = the MPC = ____ M = ____ If the MPC = the MPS = ____ M = ____ If the MPC = the MPS = ____ M = ____ If the change in GDP = $20 billion and the change in AE = $5 billion, then the multiplier = ____ and the MPC = _____ and the MPS = _____. .25 4 .10 10 .75 4 .25

20 Key Formula:  AE x M =  GDP
M = 1/MPS or 1/1-MPC or GDP/ AE If the GDP gap is $100 billion, how much must AE (C, I, G, or Xn) increase to return the economy to YF if the MPC = .80? 5 M = 1/1-MPC = 1/ = 1/.20 = _____  AE x M =  GDP 20 5 ______ X ______ = Billion

21 Key Formula:  AE x M =  GDP
M = 1/MPS or 1/1-MPC or GDP/ AE If the GDP gap is $40 billion and the MPS = .25, what amount must AE increase to close the GDP gap? 4 M = 1/MPS = 1/.25 = _____  AE x M =  GDP ______ X ______ = 40 Billion 10 4

22 Key Formula:  AE x M =  GDP
M = 1/MPS or 1/1-MPC or GDP/ AE If the economy is in a recession and has a GDP gap of $50 billion, how much must government increase G to close the GDP gap and return to full employment, assuming an MPS of .20? 5 M = 1/MPS = 1/.20 = _____  AE x M =  GDP ______ X ______ = 50 Billion 10 5

23 If $500 billion in AE  $1000 billion in GDP, then how much would G have to  to reach a YF of $2000 billion? $2000B $1000B $500B $200B $100B Explanation: 1000/500 = 2 = Multiplier = GDP/AE AE x Multiplier = GDP G x 2 = 2000 G = 1000

24 The value of the spending multiplier decreases when?
Tax rates are decreased Exports decrease Imports decrease Government expenditures decrease The MPS increases The multiplier = 1/MPS 1/.20 = 5 1/.40 = 2.5 As MPS increases, the multiplier decreases.

25 Which of the following best explains why equilibrium income will rise by more than $100 in response to a $100 increase in G? Incomes will    taxes Incomes will   C AE  PL D. AE  MS   I E. budget deficit  AE Multiplier effect – Spending becomes Income which is either Spent or saved; the New expenditure gives rise to more income, which leads to more spending.. . .

26 In a closed economy with no taxes in which the APC is 0
In a closed economy with no taxes in which the APC is 0.75, which of the following is true? APC = fraction of income spent = .75 = 3/4ths If income is $100, then saving is $75 If income is $100, then C is $50 If income is $200, then saving is $50 If income is 200, then C is $75 If income is $500, then S is $100 200 x .75 = $150 in consumption, leaving $50 in saving.

27 Suppose that Yd is $1000, C is $700, and the MPC is 0. 60
Suppose that Yd is $1000, C is $700, and the MPC is If Yd increases by $100, C and S will equal which of the following? C _ S YD = 1000 C = 700 S = 300 as a starting point Yd = 100 and MPC = .60 C = .60 (100) = 60 and  S = .40 (100) = 40 = 760 C = 340 S

28 If at YF, government wants to increase its spending by $100 billion without inflation in the short run, it must do which of the following?  T by greater than $100 B  T by $100B  T by less than $100 B  T by $100 B  by less than $100 B G has a greater effect on GDP than T; there- fore the  T must be Greater than the  G to offset the increased G and prevent further Inflation.

29 If AE  from 200 to 300 solely due to a change in G leads which leads to a change in GDP of 1000 to 1500, which of the following is true? G = 100 GDP = 500 M = 5 G is 300 and the multiplier is 5 G is 100 and the multiplier is 5 G is 100 and C increases by 500 G and GDP increase by 500 each C and GDP increase by 500 each


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