AP Macroeconomics

Fun!!! With the MPC,

MPS, and
Multipliers
 Disposable Income

• Net 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 Income
• MPC = ΔC/ΔDI
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
 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
• Why does this happen?
–Expenditures and income flow
continuously which sets off a
spending increase in the
economy.
–Read pg. 199
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.
1
• Multiplier = / or 1/
1-MPC MPS

• Multipliers are (+) when there is an

increase in spending and (–) when
there is a decrease
 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/ or -MPC/MPS
1-MPC
• 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 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/ = 1/ = 10
MPS .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
 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/ = -.75/ = -3
MPS .25
– Step 4: Calculate the Change in AD
• (Δ Tax) * Tax Multiplier
• (€200 billion Δ T) * (-3) = -€600 billion Δ in AD/AE
 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 = 1 - .80 = .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 t illi ] [ ¥200 t illi ] ¥50 t illi Δ AD/AE
 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/ + -MPC/ = 1- MPC/ = MPS/
MPS MPS MPS MPS = 1

• The balanced budget multiplier always = 1

 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.
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
1/1-.80 = _____
Multiplier = _________ 5

• Effect of the the increase in G:

20
_____ 5 = ______
X ______ 100 increase

• Effect of the decrease in T:

20   _____
 T of $20 billion   Yd _____ 16 C _____
4 S
16
_____ 5 = ______
X ______ 80 increase which is less than
The 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
=.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.
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? balanced
• Effect on GDP (economy)? Increase by
$50 billion
$40 billion
• Multiplier = _____
5  C = _____
(.80x50)

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
 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? ________50 billion

• A decrease in G and T of $30 billion would

decrease GDP by how much? _______ $30 billion

• Conclusion: A balanced budget increase in G

and T (spending and taxes are equal) has an
____________ effect on the economy.
expansionary
• A balanced budget decrease in spending and
taxes has an ______________ effect on the budget.
contractionary
 Spending Multiplier Formulas:
M = 1/MPS or 1/1-MPC or GDP/ AE

If the MPS = .20 .80 M = ____5

the MPC = ____

.25 4
If the MPC = .75 the MPS = ____ M = ____

.10 M = ____10
If the MPC = .90 the MPS = ____

If the change in GDP = $20 billion and the change

in AE = $5 billion, then the multiplier = ____ and
the MPC = _____ 4 and the MPS = _____. .75
.25
 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-.80 = 1/.20 = _____
 AE x M =  GDP
20
______ 5 = 100 Billion
X ______
 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
10 4
______ X ______ = 40 Billion
 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
______
10 X ______
5 = 50 Billion
 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 Explanation:
• $500B 1000/500 = 2 = Multiplier =
GDP/AE
• $200B AE x Multiplier = GDP
G x 2 = 2000
• $100B G = 1000
 The value of the spending multiplier
decreases when?

A. Tax rates are The multiplier = 1/

decreased MPS
1/.20 = 5
B. Exports decrease
1/.40 = 2.5
C. Imports decrease As MPS increases,
D. Government the
multiplier decreases.
expenditures
decrease
E. The MPS increases
Which of the following best explains
why equilibrium income will rise by
more than $100 in response to a $100
increase in G?
A. Incomes will    taxes

B. Incomes will   C Multiplier effect –

C. AE  PL
D. AE  MS   I
E. budget deficit  AE
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?
APC = fraction of income spent = .75 = 3/4ths

A. If income is $100, then saving is $75

B. If income is $100, then C is $50
C. If income is $200, then saving is $50
D. If income is 200, then C is $75
E. If income is $500, then S is $100
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
C _ S following?
A. 420 280
B. 600 400 YD = 1000
C = 700
C. 660 320 S = 300 as a starting point
D. 660 440 Yd = 100 and MPC = .60
E. 760 340 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?
A.  T by greater than $100 B
B.  T by $100B G has a greater effect
C.  T by less than $100 B on GDP than T; there-
D.  T by $100 B fore the  T must be
Greater than the  G to
E.  by less than $100 B 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 = 100
A. G is 300 and the multiplier is 5 GDP = 500
M=5
B. G is 100 and the multiplier is 5
C. G is 100 and C increases by 500
D. G and GDP increase by 500 each
E. C and GDP increase by 500 each