Multiplier Macroeconomics. In Macroeconomics, it is important to understand the following relationships:. Disposable income and consumption Disposable income and saving The interest rate and investment Changes in spending and changes in real GDP.
Disposable income and consumption
Disposable income and saving
The interest rate and investment
Changes in spending and changes in real GDP
Disposable (after-tax) income equals
savings (S) plus consumption (C).
Economists define personal saving as “not spending” or “that part of disposable income not consumed.”
In the aggregate, households increase their spending as their disposable income rises and spend a larger proportion of a small disposable income than of a large disposable income.
There is a direct relationship between saving and disposable income but saving is a smaller proportion of a small DI than of a large DI. Households consume a smaller and smaller proportion of DI as DI increases; therefore, they must be saving a larger and larger proportion.
Households can consume more than their incomes by liquidating (selling for cash) accumulated wealth or by borrowing.
Real Interest Rates
Changes in wealth, expectations, interest rates, and household debt will shift consumption in one direction and saving in the opposite direction.
In contrast, a change in taxes will result in consumption and saving moving in the same direction. A tax increase shifts both downward, and a tax decrease shifts them upward.
Income minus taxes = Disposable Income
The proportion, or fraction, of any change in income consumed is called the marginal propensity to consume (MPC). The MPC is the ratio of a change in consumption to a change in the income that caused the consumption change.
MPC = change in consumption
change in income
The fraction of any change in income saved is the marginal propensity to save (MPS). The MPS is the ratio of a change in saving to the change in income that brought it about:
MPS = change in saving
change in income
When C or Ig or G or Xn increases, real GDP also increases.
But the total increase in real GDP is larger than the initial increase in spending.
The multiplier is the amount by which a change in any component of spending is magnified or multiplied to determine the change that it generates in real GDP.
A change in spending ultimately changes output and income by more than the initial change in investment spending. This is called the multiplier effect.
The Council of Economic Advisers, which advises the U.S. President on economic matters, has estimated that the actual multiplier effect for the United States is about 2.