Fiscal Policy 2 (the math)

Multiplier Effect

A small change in G is magnified or "multiplied" across the economy such that the impact on AD is bigger than the initial change in G.

The multiplier effect works because...

It increases household income which leads to an increase in C.

Formula for Spending Multiplier

1/MPS

Formula for Tax Multiplier

Spending Multiplier - 1

What's the relationship between the MPS and the MPC?

MPS + MPC = 1

What does MPS stand for?

"Marginal Propensity to Save" (which means, what percentage of every new found dollar of income do you Save?)

What does MPC stand for?

"Marginal Propensity to Consume" (which means, what percentage of every new found dollar of income do you use for Consumption?)

If the MPC is .8, what is the MPS?

.2

If the MPS is .6, what this the MPC?

.4

If the MPC is .1, what is the MPS?

.9

If the MPC is .75, what is the MPS?

.25

If the MPC is .75 and the MPS is .25, what is the Spending Multiplier?

1/.25 = 4

If the MPC is .75 and the MPS is .25, what is the Tax Multiplier?

1/.25 = 4

4 - 1 = 3

TM = 3

If the MPC is .8, what is the Spending Multiplier?

1/.2 = 5

If the MPC is .8, what is the Tax Multiplier?

5 - 1 = 4

If the MPC is .9, what is the Spending Multiplier

1/.1 = 10

Why should I care about this?

You're going to use the Spending Multiplier and Tax Multiplier to figure out how to close a recessionary gap or inflationary gap.