a i 3 Macroeconomics The Multiplier ‘An initial change in any of the components of aggregate demand (AD) will lead to further changes in the economy and an even larger final change in real gross domestic product (GDP). That is, any initial change in spending will be multiplied as it impacts the economy. The final impact of an initial change in spending can be calculated using the spending multiplier. The size of the final impact of an initial change in spending on real GDP is affected by the amount of additional spending that results, when households receive additional income, called the marginal propensity to consume, or MPC. The MPC is the key to understanding the multiplier, so the first step in understanding the multiplier is to understand the MPC, ‘The MPC is the change in consumption divided by the change in disposable income (DI). It isa fraction cof any change in DI that is spent on consumer goods (C): MPC = AC / ADI. "The marginal propensity to save (MPS) isthe fraction saved of any change in disposable income. The MPS is equal to the change in saving divided by the change in DI: MPS = AS / ADI. ‘The MPC measures changes in consumption when income changes. The MPC is distinct from the average propensity to consume (APC), which measures the average amount of the total income households spend or save The APCis the ratio of C to disposable income, or APC = C/ DI. ‘The average propensity to save (APS) is the ratio of savings (S) to disposable income, or APS = $ / DI. 1. Fill in the blanks in Table 3-2.1. @ Table 3-2.1 Average Propensities to Consume and to Save Disposable income | Consumption | Saving | aPC | APS so $2,000 | -$2,000 | — = $2,000 $3600 |-si,600 | te | 08 $4,000 $5,200 | -81,200 $6,000 $6,800 | S800 $8,000 $0,400 | S400 $10,000 $10,000 30 $12,000 $11,600 $400 873, Macroeconomics ACTIVITY 3-2 conmneo) 2. Fillin the blanks in Table 3-2.2, @ rabes.22 ‘Marginal Propensities to Consume and to Save Disposable 7 income Consumption | Saving | MPC | MPS $12,000 $12,100 $100 = = $13,000 $13,000 so | 090 0.10 $14,000 $13,800 $200 $18,000 $14,500 $500 $16,000 $15,100 $900 $17,000 415600 $1,400 3. Explain why the sum of MPC and MPS must always equal 1 ‘The Multiplier ‘The following example illustrates how an initial change in a component of AD results in an even larger change in real GDP (i.e, the multiplier process). ‘The people in Econoland live on an isolated island, One year a stranger arrives and builds a factory to make seashell charms, The factory is considered an investment on Econoland. If the MPC on the island is 75 percent, or 0.75, it means that Econoland residents consume 75 percent of any change in income and save 25 percent of any change in income. The additional spending generates additional income and eventually a multiple increase in income. This is called the multiplier effect. When they hear about the multiplier effect, the islanders are thrilled about the new factory because they like the idea of additional income. The residents of Econoland want to know what would eventually happen to the levels of GDP, consumption, and saving on the istand as the new spending works its way through the economy. Luckily there isa retired economist on Econoland who offers a brief statement of the multiplier. “It's simple,” he says, “One person's spending becomes another person's income.” The economist gives a numerical example, as shown in Table 3-2. shows the process," he says. The rounds refer to the movement of spending, from resident to resident. His example stops at four rounds and the rest of the rounds are added together to cover the total effect on all Econoland’s citizens. 88 ‘Advanced Haceent Economic: Macosonamics Sadet Resource Manil © Counel fr Keno facto, NewYork NYr i 3, Macroeconomics ACTIVITY 3-2 Sonat wm @ Table 3-2.3 Changes in Econoland’s GDP, Consumption, and Saving Round Income (GDP) Consumption spending Saving Round 1 | $1,000 0.75 of $1,000 0.25 of $1,000 = $750.00 = $250.00 Round 2 | One person's spending becoming 0.75 of $750 0.25 of $750 ‘another person's income: $750.00 = $562.50 = $187.50 Found 3 | The next person’s spending becoming | 0.75 of $562.50 0.25 of $562.50 another person's income: $562.50 = $421.88 = $140.62 Found 4 | The next person’s spending becoming | 0.75 of $421.88 0.25 of $421.88, another person's income: $421.88 $316.41 $105.47 Rounds . . 3 continue : s : ‘All rounds | Final outcome for income (GDP) Final outcome for Final outcome 1/(1~0.75) x $1,000 =4x$1,000 | consumption spending | for saving 0.25 of = $4,000 0.75 of $4,000 = $3,000 | $4,000 = $1,000 The retired economist summarizes the multiplier effect for the crowd of Econolanders. “This shows us thatthe factory isan investment that has a multiplied effect on our GDB. In this case, the multiplier is 42” He adds, “It appears to be magic, but itis simply that one person's spending becomes another person's income.” The islanders nod with agreemnent but also look puzzled, so the old professor asks the citizens a series of questions, How would Econlanders answer these questions? 4, Would the multiplier be larger or smaller if you saved more of your additional income? 5. What do you think would happen if all Econolanders saved all of the change in their incomes? 66. What would happen if you spent all of the change in your income? ‘The professor then points out that a new road around the island or a new bridge built by the island government over the lagoon would also have a multiplied effect on GDP. He also tells them that ifthe government of Econoland lowers taxes, the citizens would have more income to spend, which would cause 4 multiplier effect. He notes that there is another side to this. If taxes are raised, there is a multiplier effect, which decreases income and GDP by a multiple amount. 8990 3 Macroeconomics ACTIVITY 3-2 (connnven) Multiplier Formulas and Terms MPC = AC/ ADI MPS=AS/ ADI Spending Multiplier = 1 / (1 MPC) or 1 / MPS How to use the spending multiplier: Change in GDP = change in AD component x spending multiplier. When to use the spending multiplier: ‘When there is a change in a component of AD. ‘When the government changes taxes, it will also affect AD. If taxes are decreased, consumers (or businesses) have more disposable income and will increase spending, When the government raises taxes, households (or businesses) have less disposable income and will decrease spending. The basic multiplier effect is the same, but with two differences. First, increasing taxes decreases spending, and decreasing taxes increases spending, The effect of taxes on spending is negative, so the tax multiplier has a negative sign. Second, taxes are not a component of AD. When taxes change, consumers (or businesses) will change their spending by only part of that amount, determined by the MPC. So, for every additional dollar in disposable income, spending will only increase by $MPC. Therefore, the numerator of the tax multiplier is MPC, rather than 1 @ Student Alert: Make sure to use the tax multiplier when the change affecting AD is a change in taxes! ‘Tax Multiplier = -MPC /(1 - MPC) =~ MPC /MPS How to use the tax multiplier: Change in GDP Jhange in taxes x tax multiplier. When to use the tax multiplier: When there is a change in lump-sum taxes. ‘Note: Remember that the tax multiplier has a negative sign. Quick Quiz on Multipliers 7. What is the value of the tax multiplier if the MPC is 0.80? 8, What is the value of the spending multiplier if the MPC is 0.672 9. What is the tax multiplier if the MPS is 0.25% ‘Advanced acement Economia Macotconomis: Stent Reource Manual © Coun for Economic Bavcaton, Now York, NXrey {ia Macroeconomics ACTIVITY 3-2 The Multiplier ‘An initial change in any of the components of aggregate demand (AD) will lead to further changes in the economy and an even larger final change in real gross domestic product (GDP). That is, any initial change in spending wall be multiplied as it impacts the economy. The final impact of an initial change in spending can be calculated using the spending multiplier. ‘The size of the final impact of an initial change in spending on real GDP is affected by the amount of additional spending that results when households receive additional income, called the marginal propensity to consume, ot MPC, The MPC is the key to understanding the multiplier, so the first step in understanding the multiplier is to understand the MPC. ‘The MPC is the change in consumption divided by the change in disposable income (DI). Its fraction of any change in DI that is spent on consumer goods (C): MPC = AC/ ADI. ‘The marginal propensity to save (MPS) is the fraction saved of any change in disposable income. The MPS is equal to the change in saving divided by the change in DI: MPS = AS / ADI. ‘The MPC measures changes in consumption when income changes. The MPC is distinct from the average ‘propensity to consume (APC), which measures the average amount of the total income households spend or save, ‘The APC is the ratio of C to disposable income, or APC = C/ DI. ‘The average propensity to save (APS) is the ratio of savings (S) to disposable income, ot APS = $ DI. 1. Fill in the blanks in Table 3-2.1, 7 @ Table 3-2.1 Average Propensities to Consume and to Save Disposable income | Consumption | saving | APC | APS $0 $2,000 | -$2,000 | — — $2,000 $300 | -si,600 | 16 08 $4,000 35,200 |-s1200 | i> | as $6,000 s6e00 | -se00 | 1.13 | ois $8,000 sooo | -s400 | 1.05 | O08 “stoo00 | $10,000 so | Loo [@ $12,000 $11,600 $400 94 [2.08 band Perel Economie Masson Sinn Rese Manual © Cool for Enon Edson New York, 8788 3 | Macroeconomics 2. Fill in the blanks in Table 3-2.2, @ rivies.22 Marginal Propensities to Consume and to Save Disposable : income | Consumption | Saving | MPC | MPS $12,000 g12,to0 | -sio0 | — = $13,000 $1300 =| $0 0.10 $14,000 $13,800 $200 Oat $15,000 $14,500 $500 2.20 $16,000 $15,100 sooo [0.60 | Oud $17,000 415600 | si400 | 0.50 | 0.50 3. Explain why the sum of MPC and MPS must always equal 1. Consumptier Onongc. The Multiplier ‘The following example illustrates how an initial change in a component of AD results in an even larger change in real GDP (ic., the multiplier process). ‘The people in Econoland live on an isolated island. One year a stranger arrives and builds a factory to ‘make seashell charms, The factory is considered an investment on Econoland. If the MPC on the island is 75 percent, ot 0.75, it means that Econoland residents consume 75 percent of any change in income and save 25 percent of any change in income. The additional spending generates additional income and eventually a multiple increase in income. This is called the multiplier effect. When they hear about the multiplier effect, the islanders are thrilled about the new factory because they like the idea of additional income. ‘The residents of Econoland want to know what would eventually happen to the levels of GDP, ‘consumption, and saving on the island as the new spending works its way through the economy. Luckily there isa retired economist on Econoland who offers a brief statement of the multiplier.“Its simple? he says, One person's spending becomes another person’s income.” The economist gives a numerical example, as shown in Table 3-2.3.“‘This shows the process” he says. The rounds refer to the movement of spending from resident to resident. His example stops at four rounds and the rest of the rounds are added together to ‘cover the total effect on all Econoland!s citizens. Advanced Pacerent Econom Macronconomic: Stade Reource Manta © Coal Econom Eton Nor Yk, NY.fis ‘Macroeconomics ACTIVITY 3-2 (connnueny 6 Table 3-2.3 Changes in Econoland’s GDP, Consumption, and Saving Round Income (GDP) Consumption spending Saving Round 1 | $1,000 0.75 of $1,000 0.25 of $1,000 = $750.00 = $250.00 Round 2 | One person's spending becoming 0.75 of $750 0.25 of $750 ‘another person’s income: $750.00 = $562.50 = $187.50 Round 3 | The next person's spending becoming | 0.76 of $562.50 0.25 of $562.50 ‘another person's income: $562.60 = $421.88 = $140.62 Found 4 | The next person's spending becoming | 0.75 of $421.88 0.25 of $421.88 ‘another porson’s income: $421.88 = $316.41 = $105.47 Rounds ' : continue : : a All rounds | Final outcome for income (GDP) Final outcome for Final outcome 11 (1 = 0.75) x $1,000 = 4 x $1,000 consumption spending | for saving 0.25 of = $4,000 0.75 of $4,000 = $3,000 | $4,000 = $1,000 ‘The retired economist summarizes the multiplier effect for the crowd of Econolanders.“‘This shows us that the factory is an investment that has a multiplied effect on our GDP. In this case, the multiplier is 4.” He adds, “It appears to be magic, but it is simply that one person’ spending becomes another person's income.” ‘The islanders nod with agreement but also look puzzled, so the old professor asks the citizens a series of questions, How would Econlanders answer these questions? 4. Would the multiplier be larger or smaller if you saved more of your additional income? er 5. What do you think would happen if all Econolanders saved all of the change in their incomes? 6. What would happen if you spent all ofthe change in your income? The professor then points out that a new road around the island or a new bridge built by the island government over the lagoon would also have a multiplied eflect on GDP. He also tells them that if the government of Econoland lowers taxes, the citizens would have more income to spend, which would cause a multiplier effect. He notes that there is another side to this. If taxes are raised, there is a multiplier effect, ‘which decreases income and GDP by a multiple amount. ‘Adraned acme Economies Mocroconomic: Steen Rsuiee Marital © Coun or Fzanomic Bleaton, NewYork NY. 89é Macroeconomics ACTIVITY 3-2 cconnwwen) ‘Multiplier Formulas and Terms MPC = AC/ ADI MPS = AS/ ADI Spending Multipli 1/1 =MPC) or 1/ MPS How to use the spending multiplier: Change in GDP = change in AD component x spending multiplier. When to use the spending multiplier: ‘When there is a change in a component of AD. ‘When the government changes taxes, it will also affect AD. If taxes are decreased, consumers (or businesses) have more disposable income and will increase spending. When the government raises taxes, households (or businesses) have less disposable income and will decrease spending. The basic multiplier cffect isthe same, but with two differences. First, increasing taxes decreases spending, and decreasing taxes increases speniding, The effect of taxes on spending is negative, so the tax multiplier has a negative sign. Second, taxes are not a component of AD. When taxes change, consumers (or businesses) will change their spending by only part of that amount, determined by the MPC. So, for every additional dollar in disposable income, spending will only increase by $MPC. Therefore, the numerator of the tax multiplier is MPC, rather than 1. @ Student Alert: Make sure to use the tax multiplier when the change affecting AD is a change in taxes! ‘Tax Multiplier ‘MPC /MPS MPC /(1 - MPC) = How to use the tax multiplier: Change in GDP = change in taxes x tax multiplier. When to use the tax multiplier: When there is a change in lump-sum taxes. Note: Remember that the tax multiplier has a negative sign. Quick Quiz on Multipliers 7. What is the value of the tax multiplier if the MPC is 0.80? _— 4 8, What i the value of the spending multiplier ifthe MPC is 0.672 2 9. What is the tax multiplier if the MPS is 0.252 90 vanced Pacerent Benois Macroeconomic Stent Reouce Manual © Coun fo Economic Béction, Ne York, NY,