Macro Chapter 8

Presentation 1- Marginal Propensities and the Multiplier

Income, Consumption, and Savings

• In general, as income goes up, people spend more--- Direct relationship

• People also tend to save more as income increases

• Savings = Disposable Income - Consumption

45-Degree Line

• A reference line used to compare consumption and savings

• Consumption = DI• If you assume that the reference line is DI,

then the vertical distance between the 45 degree line and a given consumption line will tell you the amount of savings

Income and Consumption

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1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

0 2000 4000 6000 8000 10000

Cons

umpti

on (b

illio

ns o

f dol

lars

)

Disposable Income (billions of dollars)

Consumption and Disposable Income, 1983-2005

45° Reference LineC=DI

83

8685

84

8889

9190

87

9293

9495

01

9796

9998

00

02

05

03

04

ConsumptionIn 1992

SavingIn 1992

45°

C

Dissaving

• Spending more on consumption than your after-tax income

Break-Even Income

• The level of disposable income at which households will spend all DI and have zero savings

Average Propensity to Consume (APC)

• the fraction or % of income that is consumed

APC =Consumption

Income

Average Propensity to Save (APS)

• The fraction or % of income that is saved

APS =Saving

Income

Average Propensities Contd.

• Since DI is either consumed or saved….• APC + APS = 1• Ex- if APS is .04, APC must be .96

Marginal Propensity to Consume (MPC)

• The fraction that is spent from a change in DI • Ex- If income increases from 470B to 490B,

and consumption increases from 435B to 450B

• MPC = (450-435)/490-470= 15/20 = .75

MPC =Change in Consumption

Change in Income

Marginal Propensity to Save (MPS)

• Ex. If income increases from 470 B to 490B and Savings increases from 20B to 25B calculate MPS and MPC

• MPS = (25-20)/(490-470) = 5/20 = .25• *** MPS + MPC = 1 so MPC = 1-.25 = .75

MPS =Change in SavingChange in Income

The Multiplier Effect

• There is a direct relationship between changes in spending and real GDP

• ***A change in total spending leads to a larger change in GDP (multiplies)

• The money initially spent goes to profits, wages, rents etc. which are then spent in a chain reaction down the line

The Multiplier Effect

Multiplier =Change in Real GDP

Initial Change in Spending

Multiplier Effect and Marginal Propensities

Multiplier =

-or-

Multiplier =

1

1 - MPC

1

MPS

Sample Problem

• The MPC is .8 and a business increases investment by $5 Billion. What is the multiplier? How much increase in GDP?

• Multiplier = 1/MPS or 1/1-MPC

= 1/(1-.8) = 5

GDP = 5 x 5 = 25 Billion increase

The Multiplier Effect(1)

Change inIncome

(2)Change in

Consumption(MPC = .75)

(3)Change in

Saving(MPS = .25)

Increase in investment of $5Second RoundThird RoundFourth RoundFifth RoundAll other rounds Total

$ 5.003.752.812.111.584.75

$ 20.00

$ 3.752.812.111.581.193.56

$ 15.00

$ 1.25.94.70.53.39

1.19$ 5.00

Rounds of Spending1 2 3 4 5 All

$20.00

15.2513.6711.56

8.75

5.00$5.00

$3.75

$2.81$2.11

$1.58$4.75

ΔI=$5 billion

The MPC and the Multiplier

10

5

4

3

2.5

.67

.75

.8

.9

MPC Multiplier