Spending and Tax Multipliers

Basic Vocabulary

• Multiplier effect: An initial change in spending sets off a magnified spending chain in the economy.
• Marginal propensity to consume (MPC): The portion of each new dollar of disposable income that consumers will spend rather than save.
• Marginal propensity to save (MPS): The portion of each new dollar of disposable income that consumers will save rather than spend.

MPC and MPS

• Marginal Propensity to Consume (MPC):

  • Calculated by dividing the change in consumption by the change in disposable income.
  • Example: If income increases by $10,000 (from $50,000 to $60,000) and consumption increases by $9,000 (from $45,000 to $54,000), then MPC = 0.9 ($9,000/$10,000).

• Marginal Propensity to Save (MPS):

  • Calculated by dividing the change in savings by the change in disposable income.
  • Example: With the same income increase, if savings increase by $1,000, then MPS = 0.1 ($1,000/$10,000).

• MPC + MPS = 1: For every new dollar, it is either saved or consumed.

Spending Multiplier

• Initial changes in spending are magnified in the economy using the spending multiplier.

• Example of spending chain:

  • Business invests $10 → New income, MPC = 0.8 → People spend $8, save $2 → $8 becomes new income, spend $6.40, save $1.60 → Continues until negligible amounts.

• Spending Multiplier Formula: 1/MPS

• Calculations may need conversion from MPC to MPS (1 - MPC = MPS) to use this formula.

• Impact of Exports/Imports:

  • Increase in imports decreases real GDP.
  • Increase in exports increases real GDP.

Tax Multiplier

• Determines change in spending when taxes change.

• Opposite of spending multipliers; shows how much spending is reduced with tax increases.

• Tax Multiplier Formula: -MPC/MPS

• Example: If MPC = 0.8 and taxes increase by $50:

  • Tax multiplier = -0.8/0.2 = -4
  • GDP change: -4 × $50 = -$200

• Tax multipliers are smaller than spending multipliers:

  • Spending has a direct effect on the economy.
  • Taxes influence spending indirectly through disposable income.

Key Terms to Review

• Marginal Propensity to Save (MPS): Portion of income saved, crucial for understanding fiscal policy impacts.
• Marginal Propensity to Consume (MPC): Portion of income spent, plays a role in consumer behavior analysis.
• Multiplier Effect: Initial spending changes cause larger economic activity changes.
• Spending Multiplier: Measures overall economic impact of spending changes.
• Tax Multiplier: Measures economic output change due to tax changes, important for fiscal policy evaluation.