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Economics

Economics. 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.

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Economics

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  1. Economics Fun!!! With the MPC, MPS, and Multipliers

  2. Disposable Income • Net Income • Paycheck • After-tax income

  3. 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

  4. 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

  5. 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!

  6. The Spending Multiplier Effect • Why does this happen? • Expenditures and income flow continuously which sets off a spending increase in the economy.

  7. 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.

  8. 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

  9. EXAMPLE CALCULATIONS • Business report states that in 2009, consumers spent only 80cents of each $, .: 1/1-mpc (1/1-.80) or 1/mps (1/.20) = ? • Now calculate spending multiplier for mpc or .90; .75; .60; .50

  10. 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

  11. Tax multiplier calculations • -mpc/1-mpc or –mpc/mps OR……… • Assume a tax hike of .90 to equal • -.90/10……..answer? • Now calculate other tax multipliers with mpc of .80; .75; .60; .50

  12. Multiplier Table • Govt…..InvstmntSpndng… Tax • MPC… .Multiplier…. Multiplier…. Multiplier • 0.90 10.0 10.0 –9.0 • 0.80 5.0 5.0 –4.0 • 0.75 4.04.0 –3.0 • 0.60 2.5 2.5 –1.5 • 0.50 2.02.0 –1.0 • “ALWAYS” RULES (A surefire way to remember multipliers) • The investment multiplier is always equal to the same value as the government spending multiplier. • The investment and government spending multipliers are alwayspositive. • The tax multiplier is alwaysnegative

  13. 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

  14. 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

  15. 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

  16. 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

  17. No – G has a greater effect! 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.

  18. 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: 1/1-.80 5 Multiplier = _________ = _____ 20 5 100 increase _____ X ______ = ______ 20 16 4  T of $20 billion  Yd _____  _____ C _____ S 16 5 80 increase which is less than The increase of 100 from G. _____ X ______ = ______

  19. What would be the effect on the economy (GDP) of a decrease of $100 billion in G. Assume the MPS =.25 • What would be the effect of an increase in taxes of $100 billion? 100 X 4 = $400 billion decrease in GDP 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.

  20. 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 billion • Multiplier = _____  C = _____ balanced $40 billion (.80x50) 5 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

  21. 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? ________ • 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 billion expansionary contractionary

  22. Spending Multiplier Formulas: M = 1/MPS or 1/1-MPC or GDP/ AE 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 = _____. .80 5 .25 4 .10 10 .75 4 .25

  23. 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

  24. 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

  25. 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 ______ X ______ = 50 Billion 10 5

  26. 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 • $100B Explanation: 1000/500 = 2 = Multiplier = GDP/AE AE x Multiplier = GDP G x 2 = 2000 G = 1000

  27. The value of the spending multiplier decreases when? • Tax rates are decreased • Exports decrease • Imports decrease • Government expenditures decrease • The MPS increases The multiplier = 1/MPS 1/.20 = 5 1/.40 = 2.5 As MPS increases, the multiplier decreases.

  28. 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.. . .

  29. In a closed economy with no taxes in which the MPC is 0.75, which of the following is true? • If income is $100, then saving is $75 • If income is $100, then C is $50 • If income is $200, then saving is $50 • If income is 200, then C is $75 • If 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.

  30. 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? • 420 280 • 600 400 • 660 320 • 660 440 • 760 340 C _ S YD = 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

  31. 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.

  32. If AE  from 200 to 300 solely due to a change in G leads to a change in GDP of 1000 to 1500, which of the following is true? • G is 300 and the multiplier is 5 • G is 100 and the multiplier is 5 • G is 100 and C increases by 500 • G and GDP increase by 500 each • C and GDP increase by 500 each G = 100 GDP = 500 M = 5

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