The Multiplier Effect Review for AP Economics (page 2)
Review questions for this study guide can be found at:
Main Topics: The Multiplier Effect and Spending Multiplier, Public and Foreign Sectors, The Tax Multiplier, Balanced Budget Multiplier
The most simple circular flow consists solely of consumers and firms; in other words, GDP = C+ I.But the public sector (G) and foreign sector (X– M) are also important sources of domestic spending and income. Inclusion of these two sectors provides very little in the way of complications; they introduce the concept of the spending multiplier, the tax multiplier, and the balanced budget multiplier. This also paves the way for fiscal policy aimed at macroeconomic stability.
The Multiplier Effect and Spending Multiplier
When you buy an ear of corn at the farmer's market, those dollars serve as income to several people. The farmers use those dollars to pay employees, to run their farm equipment, and to buy their own food. Farm employees use those wages to buy bacon, pay the rent, and many other goods and services. The circular flow explains how the injection of a few dollars of spending creates many more dollars of spending. Follow the dollars for a few rounds to see how it works. With the marginal propensity to consume of .80, if households receive a $1 of new income they spend $.80 and save $.20.
Round 1:Firms increaseinvestment spending by $10,which acts as an injection of new money into the economy.
Round 2:The $10acts as income to resource suppliers (households) and with an MPC = .80, households spend $8and save $2.
Round 3:The $8of new consumption spending (C) is income for other households and they also spend 80 percent, or $6.40and save $1.60.
Round 4:The $6.40of new Cis income for other households and they spend 80 percent, or $5.12, and save $1.28.
This process repeats. Each time the dollars circulate through the economy, 80 percent is spent, and 20 percent is saved. After only four rounds, there has been $10 + 8 + 6.40 + 5.12 = $29.52 of new GDP. The process continues until households are trying to consume 80 percent of virtually nothing and the increase in new GDP comes to an eventual stop.
This is called the multiplier effect. A change in any component of autonomous spending creates a larger change in GDP. The discussion of the "rounds" of spending above implies that the marginal propensities to consume and save play a critical role in determining the magnitude of the multiplier. There are two equivalent ways to calculate the multiplier if you know the MPC or MPS. The magnitude of the spending multiplieris found by taking a ratio:
Multiplier = 1/(1 – MPC) = 1/ (1 – .80) = 5.
Since MPC + MPS = 1,
Multiplier = 1/MPS = 1/.20 = 5.
The spending multiplier can be found by using one of the following equations:
Some common autonomous multipliers are:
The Public and Foreign Sectors
The inclusion of government spending (G) and net exports (X– M) act in the very same way as the change in investment illustrated in the above example.
Government Spending (G)
With the MPC = .80, we have found the spending multiplier equal to 5. If autonomous government spending is incorporated into the circular flow model, the multiplier effect is again felt throughout the economy. If G= $20, we could expect those $20 to multiply to $100 in new GDP.
Net Exports (X –M)
The final sector of the macroeconomy is the foreign sector. The addition or subtraction (if imports exceed exports) of autonomous net exports is an increase (or decrease) of dollars in the circular flow. Using a spending multiplier of 5, if (X– M) = $10, GDP would increase by $50.
The Tax Multiplier
The above discussion of the public sector shows that when the government injects money into the economy (G), it multiplies by a factor of the spending multiplier. But the government can also have an impact on aggregate expenditures and real GDP by changing taxes and/or transfers.
The Multiplier Effect
Recipients of a decrease in taxes treat it as an increase in disposable income. The typical household increases consumption by a factor of the MPC and increases saving by a factor of the MPS. It is important to keep in mind that less than 100 percent of this increase in disposable income circulates through the economy because most households save a proportion of it.
The MPC is equal to .90, and the government transfers back tax revenue to consumers by sending each taxpayer a $200 check. With an MPC = .90, $180 is consumed and $20 is saved. The multiplier process kicks in, but not on the entire $200, only on the consumed portion of $180. The multiplier being 1/.10 = 10, GDP increases by $1800.
In other words, a $200 change in tax policy (a tax rebate in this case) caused an $1800 change in real GDP. This tax multiplier of 9 measures the magnitude of the multiplier process when there is a change in taxes.
The Difference in Multipliers
With an MPC = .90, the spending multiplier is 10, but the tax multiplier is smaller, Tm = 9. Why? The spending multiplier begins to work as soon as there is a change in autonomous spending (C, I, G, net exports) but the tax multiplier must first go through a person's consumption function as disposable income. In that first "round" of spending, some of those injected dollars are leakages in the form of savings. In our example above, 10 percent of those injected dollars fail to be recirculated and therefore the final multiplier effect is smaller. The relationship between the spending multiplier and the tax multiplier (Tm) is:
Tm = MPC × (Spending multiplier) = .90 × (l/ .10) = 9 in our example
Be preparedto respond to a free-response question that asks you to explain why the tax multiplier is smaller than the spending multiplier.
The MPC = .80 and the government decides to impose a $50 increase in taxes. What happens to GDP?
Tm = .80 × Multiplier = .80 × (1/.20) = 4
Because the tax multiplier is equal to 4, we determine that GDP falls by $200. How do we know? Because taxes were increased, disposable income falls, consumption falls, causing GDP to fall, in this case by a factor of 4.
The tax multiplier is found by:
The Balanced-Budget Multiplier
The government both collects and spends tax revenue. In a simplified model, if the dollars spent equal the dollars collected, the budget is balanced. We have already discussed how the spending multiplier and tax multiplier are different. A quick example of a balanced budget policy illustrates what is called the balanced-budget multiplier.
The government wants to spend $100 on a federal program and pay for it by collecting $100 in additional taxes. The MPC = .90 in this example.
The spending multiplier = 10 implies that the $100 of new spending (G) creates a $1000 increasein real GDP.
The tax multiplier Tm = 9 implies that a $100 increase in taxes decreasesreal GDP by $900.
Balanced Budget Effect
Change in real GDP = +$1000 – $900 = +$100
So a $100 increase in spending, financed by a $100 increase in taxes, created only $100 in new GDP. The balanced-budget multiplier is always equal to one, regardless of the MPC.
- Balanced-Budget Multiplier = 1
Review questions for this study guide can be found at:
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