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.
• 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 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
 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
 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/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 trillion ] + [ - ¥200 trillion ] = ¥50 trillion 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/MPS + -MPC/MPS = 1- MPC/MPS = MPS/MPS = 1
• The balanced budget multiplier always = 1
 Does a change in G have
the same effect on GDP as
a Nochange in T?
– 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 = _____
5
Multiplier = _________
• Effect of the the increase in G:

20 5 100 increase
_____ X ______ = ______

• Effect of the decrease in T:

 T of $20 billion   Yd _____
20   _____
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 ____________
expansionary effect on the economy.
• A balanced budget decrease in spending
and taxes has an ______________
contractionary effect on
the budget.
Spending Multiplier Formulas:
M = 1/MPS or 1/1-MPC or GDP/ AE

If the MPS = .20 the MPC = .80

____ M = ____
5

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

If the MPC = .90 the MPS = ____

.10 M = ____
10

If the change in GDP = $20 billion and the

change in AE = $5 billion, then the
multiplier = ____
4 and the MPC = _____
.75 and
the MPS = _____.
.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
______ X ______ = 100 Billion
 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
______ 5
X ______ = 50 Billion
 If $500 billion in AE  $1000 billion
in GDP, then how much would G
have to  to reach a YF of $2000
• $2000B billion?
• $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 =

decreased 1/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 –

Spending becomes
C. AE  PL Income which is either
Spent or saved; the
New expenditure gives
D. AE  MS   I
rise to more income,
which leads to more
E. budget deficit  AE 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
C _ S the 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. GDP =
G is 300 and the multiplier is 5
500
B. G is 100 and the multiplier is 5
M=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