AP MacroeconomicsFun!!! With the MPC, MPS, and Multipliers

Disposable IncomeNet Income

Paycheck

After-tax income

Marginal Propensity to Consume (MPC)The fraction of any change in disposable income that is consumed.

MPC= Change in Consumption Change in Disposable IncomeMPC = C/DI

Marginal Propensity to Save (MPS)The fraction of any change in disposable income that is saved.

MPS= Change in SavingsChange in Disposable Income

MPS = S/DI

Marginal PropensitiesMPC + MPS = 1.: MPC = 1 MPS.: MPS = 1 MPCRemember, people do two things with their disposable income, consume it or save it!

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

The Spending Multiplier EffectEx. 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 MultiplierThe 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

Calculating the Tax MultiplierWhen the government taxes, the multiplier works in reverseWhy?Because now money is leaving the circular flowTax Multiplier (note: its negative) = -MPC/1-MPC or -MPC/MPSIf there is a tax-CUT, then the multiplier is +, because there is now more money in the circular flow

MPS, MPC, & MultipliersEx. 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 MPSMPC = C/DI = .9/1 = .9MPS = 1 MPC = .10Step 2: Determine which multiplier to use, and whether its + or -The problem mentions an increase in IG .: use a (+) spending multiplierStep 3: Calculate the Spending and/or Tax Multiplier1/MPS = 1/.10 = 10Step 4: Calculate the Change in AD/AE( C, IG, G, or XN) * Spending Multiplier($50 billion IG) * (10) = $500 billion AD/AE

MPS, MPC, & MultipliersEx. 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 MPSMPS = 25%(given in the problem) = .25 MPC = 1 MPS = 1 - .25 = .75Step 2: Determine which multiplier to use, and whether its + or -The problem mentions an increase in T .: use (-) tax multiplierStep 3: Calculate the Spending and/or Tax Multiplier-MPC/MPS = -.75/.25 = -3Step 4: Calculate the Change in AD( Tax) * Tax Multiplier(200 billion T) * (-3) = -600 billion in AD/AE

MPS, MPC, & MultipliersEx. 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 MPSMPC = 4/5 (given in the problem) = .80MPS = 1 MPC = 1 - .80 = .20Step 2: Determine which multiplier to use, and whether its + or -The problem mentions an increase in G and an increase in T .: combine a (+) spending with a () tax multiplierStep 3: Calculate the Spending and Tax MultipliersSpending Multiplier = 1/MPS = 1/.20 = 5Tax Multiplier = -MPC/MPS = -.80/.20 = -4Step 4: Calculate the Change in AD[ G * Spending Multiplier] + [ T * Tax Multiplier][(50 trillion G) * 5] + [(50 trillion T) * -4][ 250 trillion ] + [ - 200 trillion ] = 50 trillion AD/AE

The Balanced Budget MultiplierThat last problem was a pain, wasnt 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 spendingWhy? 1/MPS + -MPC/MPS = 1- MPC/MPS = MPS/MPS = 1The balanced budget multiplier always = 1

Does a change in G have the same effect on GDP as a change in T?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. No G has a greater effect!

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: T of $20 billion Yd _____ _____ C _____ S _____ X ______ = ___________ X ______ = ______Multiplier = _________ = _____1/1-.805205100 increase2016416580 increase which is less thanThe increase of 100 from G.

What would be the effect on the economy (GDP) of a decrease of $100 billion in G. Assume the MPS =.25What would be the effect of an increase in taxes of $100 billion?100 X 4 = $400 billion decrease in GDPIncrease T of $100 billion decreases income (Yd) by100 billion. That means consumers will decrease spendingby $75 billion (.75 x100) and decrease saving by $25 bill.The $75 billion decrease in C X the multiplier of 4 = a $300Billion decrease in GDP.

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 billionMultiplier = _____ C = _____balanced5Effect of G: 5 x 50 = 250 billion increase in GDPEffect 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 GDPNet effect: 250 200 = $50 billion increase in GDP$40 billion(.80x50)

Key Idea: The balanced budget multiplier is 1 x GAn 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 billionexpansionarycontractionary

Spending Multiplier Formulas:If the MPS = .20 the MPC = ____ M = ____

If the MPC = .75 the MPS = ____ M = ____

If the MPC = .90 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 = _____.M = 1/MPS or 1/1-MPC or GDP/ AE.805.25.104104.75.25

Key Formula: AE x M = GDPIf 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?M = 1/MPS or 1/1-MPC or GDP/ AE AE x M = GDPM = 1/1-MPC = 1/1-.80 = 1/.20 = ___________ X ______ = 100 Billion5205

Key Formula: AE x M = GDPIf the GDP gap is $40 billion and the MPS = .25, what amount must AE increase to close the GDP gap?M = 1/MPS or 1/1-MPC or GDP/ AE AE x M = GDPM = 1/MPS = 1/.25 = ___________ X ______ = 40 Billion4104

Key Formula: AE x M = GDPIf 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?M = 1/MPS or 1/1-MPC or GDP/ AE AE x M = GDPM = 1/MPS = 1/.20 = ___________ X ______ = 50 Billion5105

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$100BExplanation: 1000/500 = 2 = Multiplier = GDP/AE AE x Multiplier = GDP G x 2 = 2000 G = 1000

The value of the spending multiplier decreases when?Tax rates are decreasedExports decreaseImports decreaseGovernment expenditures decreaseThe MPS increasesThe multiplier = 1/MPS 1/.20 = 5 1/.40 = 2.5 As MPS increases, the multiplier decreases.

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.. . .

In a closed economy with no taxes in which the APC is 0.75, which of the following is true?If income is $100, then saving is $75If income is $100, then C is $50If income is $200, then saving is $50If income is 200, then C is $75If income is $500, then S is $100

APC = fraction of income spent = .75 = 3/4ths 200 x .75 = $150 in consumption, leaving $50 in saving.

Suppose that Yd is $1000, C is $700, and the MPC is 0.60. If Yd increases by $100, C and S will equal which of the following?420280600400660320660440760340

C _ SYD = 1000 C = 700 S = 300 as a starting point Yd = 100 and MPC = .60 C = .60 (100) = 60 and S = .40 (100) = 40 700 + 60 = 760 C 300 + 40 = 340 S

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.

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 is 300 and the multiplier is 5G is 100 and the multiplier is 5G is 100 and C increases by 500G and GDP increase by 500 eachC and GDP increase by 500 each

G = 100 GDP = 500 M = 5