Unit 3

The Spending Multiplier Effect

• An initial change in spending (C, Ig, G, Xn) causes a larger change in aggregare spending, or Aggregate Demand (AD)
• Multiplier = ΔAD/ΔC, I, G, or X

Calculating the Spending Multiplier

• The Spending Multiplier can be calculated from the MPC or the MPS.
• Multiplier = 1/1-MPC or 1/MPS
• Multiplier 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 leading 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.

Consumption and Savings

• Disposable Income (DI)
• Income after taxes or net income
• DI = Gross Income - Taxes
• 2 Choices
• With disposable income, households can either
• Consume (spend money on goods and services)
• Save (not spend money on goods and services)
• Consumption
• Household spending
• The ability to consume is constrained by
• The amount of disposable income
• The propensity to save
• Do households consume if DI = 0?
• Autonomous consumption
• Dissaving
• Saving
• Household NOT spending
• The ability to save is constrained by
• The amount of disposable income
• The propensity to consume
• Do households save if DI = 0?
• NO
• APC & APS
• APC + APS = 1
• 1 - APC = APS
• 1 - APS = APC
• APC > 1 = Dissaving
• -APS = Dissaving
• Marginal Propensity to Consume (MPC)
• The fraction of any change in disposable income that is consumed.
• MPC = ΔC/ΔDI
• Marginal Propensity to Save (MPS)
• The fraction of any change in disposable income that is saved.
• MPS = Δsavings/ΔDI
• Marginal Propensities
• MPC + MPS = 1
• MPC = 1 - MPS
• MPS = 1 - MPC