AP Macroeconomics

MPC, MPS, and Multipliers

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“We are what we repeatedly do. Excellence, then, is not an act but a habit.” ~ Aristotle

Disposable Income

• Net Income

• Paycheck

• After-tax income

The Spending Multiplier Effect

• An initial change in spending (C, IG, G, XN) causes a larger change in aggregate spending, or Aggregate Demand (AD).• We are going to calculate the total

change in GDP given a change in C, Ig, G, and/or Xn

The Spending Multiplier Effect•Why does this happen?–Expenditures and income flow

continuously which sets off a spending increase in the economy.

AVERAGE Propensity to Consume/Save• The APC and APS is the percentage of disposable

income that is consumed and saved• There are only two things you can do with DI. Save

or consume it. • Given that the Japanese are big savers. Do they

have a low or high APC?• Given that Americans are big consumers do we have

a low or high APS?

MPC & MPS• Marginal Propensity to Consume– % of every extra dollar earned that is spent– ΔC/ΔDI

• Marginal Propensity to Save– % of every extra dollar earned that is saved– ΔS/ΔDI

• MPC + MPS = 1• Because you can only save or consume. What you are NOT

saving you are consuming• What you are not consuming you are saving therefore

MPC+MPS must equal 1 (100% of disposable income has been accounted for)

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!

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.

Calculating the Spending Multiplier• The Spending Multiplier can be calculated

from the MPC or the MPS.

• Multiplier = 1/MPS OR 1/1-MPC

• Change in spending*multiplier=change in GDP• Spending=changes in C, Ig, G, or Xn

Scenario

• You want to produce 50 apples by the end of October 2016. Each tree you plant will give you 5 apples. How many trees do you need to plant in the spring of 2014?

• Well, 50 divided by what will equal 5?• That’s right, 10

Putting it all together• Ex. Assume U.S. citizens spend 90¢ for every extra $1 of disposable

income 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).– Step 1: Calculate the MPC and MPS

• MPC = ΔC/ΔDI = .9/1 = .9

• MPS = 1 – MPC = .10– Step 2: Determine which Spending Multiplier to use.

• Either 1/MPS OR 1/1-MPC• Step 3: Calculate the Spending Multiplier• 1/MPS = 1/.10 = 10 OR 1/1-MPC=1/1-.9=10

– Step 4: Calculate the Change in AD• (Δ C, IG, G, or XN) * Spending Multiplier• ($50 billion Δ IG) * (10) = $500 billion ΔAD

MPS, MPC, & Multipliers• Historically speaking, the Japanese are big savers. Let’s say

that for every extra dollar of disposable income they earn they spend 25 cents. If they were each given a stimulus check by how much would aggregate demand change assuming the total stimulus was three billion dollars?– Step 1: Calculate the MPC and MPS

• MPC = ΔC/ΔDI = .25/1 = .25

• MPS = 1 – MPC = 1-.25=.75– Step 2: Determine which multiplier to use.

• Either 1/MPS OR 1/1-MPC• Step 3: Calculate the Spending Multiplier• 1/MPS = 1/.75 = 1.333 OR 1/1-MPC=1/1-.25=1.333

– Step 4: Calculate the Change in AD• (Δ C, IG, G, or XN) * Spending Multiplier• ($3 billion Δ DI) * (1.333) = $3.999 billion ΔAD

Calculating the Spending Multiplier• 1/MPS or 1/1-MPC

• The smaller the fraction of any change in income saved, the greater the respending at each round and, therefore, the greater the multiplier.

• The larger the fraction of any change in income spent, the greater the respending at each round and, therefore the, the greater the multiplier.

MPC & MPSReview and Summary

• Marginal Propensity to Consume– ΔC/ΔDI– % of every extra dollar earned that is spent

• Marginal Propensity to Save– ΔS/ΔDI– % of every extra dollar earned that is saved

• MPC + MPS = 1• 1 – MPC = MPS• 1 – MPS = MPC

MPC & MPSReview and Summary

• Multipliers (two to chose from)• 1/1-MPC• 1/MPS

• “Failure is simply the opportunity to begin again, this time more intelligently.” ~ Henry Ford

Calculating the Tax Multiplier• When the government increases taxes, the multiplier works in

reverse• Why?– Because now money is leaving the circular flow

• Tax Multiplier (note: it’s negative if taxes increase) • = -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

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 = 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 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

Change in G vs. Change in T• A change in government transfers or taxes shifts the

aggregate demand curve by LESS than an equal-sized change in G. Why? Two reasons

• First, what are transfer payments?– Unemployment compensation, Medicare, Medicaid– Transfer payments do not count as G so it doesn’t count

towards GDP

Change in G vs. Change in T• Because the transfer payment itself does not count

as an increase in G. We have to spend some of the money to see any change on AD. However a change in G itself immediately changes AD.

• People will save at least a portion of their transfer or tax cut.