The Spending Multiplier

The Spending Multiplier December-09-08 8:19 AM

- Multiplier effect - the magnified impact of a change on aggregate demand; price level stays constant, change in spending at one price value. - Marginal Propensity to Consume - the effect on domestic consumption of a change in income MPC = Change in consumption on domestic items / change in income - Marginal Propensity to Withdraw - the effect on withdrawals 0 savings, imports, and taxes - of a change in income MPW = change in total withdrawals / change in income 1 = MPC + MPW

MULTIPLIER EFFECT - Is the magnified impact of any spending change on aggregate demand. It assumes that the price levels stays the same. - The multiplier effect is the change in spending at one price level multiplied by a certain value to give the resulting change in AD Consumption Function - Calculates the amount of total consumption in an economy. It is made up of autonomous consumption that is not influenced by current income and induced consumption that is influenced by the economy's disposable income level

C = Yd

C = Autonomous consumption + MPC / Yd Consumption

Disposable Income

Marginal Propensity to Consume - Measures the rate at which consumption is changing when disposable income is changing. In a geometric fashion the MPC is the slope of the consumption function - Is the effect on domestic consumption of a change in income: MPC = change in consumption on domestic items change in income

Unit 3 - Fiscal Policy Page 1

Marginal Propensity to Withdraw (SAVE) - Withdrawals: savings, taxes, imports - Is the effect of a change in income on withdrawals. It is the change in total withdrawals as a proportion of the change in income. - Marginal propensity to save : measures the rate at which savings is changing when disposable income is changing MPW = Change in total withdrawals Change in Income Consumption

C = 50 + .85YD - This equation means that out of every extra dollar in disposable income 85 cents is spent on consumption. Therefore the MPC = .85, the MPS = .15. Disposable Income, Consumption and Savings YD

C

MPC

S

MPS

100

135

200

220

.85

-20

.15

300

305

.85

-5

.15

400

390

.85

10

.15

500

475

.85

25

.15

-35

- As income levels increase people tend to consume by the same percentage - That is the rich in society spend at the same rate as the poor

The Spending Multiplier - Is the value by which the initial spending change is multiplied to give the total change in the output. (The shift in the AD curve) a) Total change in Output = i. Initial change x spending multiplier b) Spending Multiplier = i. Total change in output (shift in the AD curve) Initial change in spending c) Spending Multiplier = i. 1 MPW - Average propensity to Consume is the ratio between a person's total and disposable income and his/her total consumption - Average Propensity to Save is the ratio between a person's total disposable income and his/her total savings

Marginal Propensity - Marginal Propensity to Consume is the ratio between a person's change in disposable income and his consumption - Marginal Propensity to Save is the ratio between a person's change in disposable income and his change in savings APC = C / Yd

APS = S / Yd

Benefits of Fiscal Policy

Unit 3 - Fiscal Policy Page 2

1. Regional focus - some part of the country may be more effected than others by the business cycle 2. Impact on spending - when the first spending is assured by the government - multiplier effect

Drawbacks of Fiscal Policy 1. Policy Delays: a) Recognition Lag - is the amount of time it takes policy makers to realize that a policy is needed b) Decision Lag - is the period that passes while an appropriate response is formulated and implemented c) Impact Lag - is the time that elapses between implementing the policy and having its effect on the economy 2. Political Visibility: a) Discretionary Fiscal Policy - highly visible elements of government activity. 3. Public Debt: a) Is the total amount owed by the federal government as a result of its past borrowing b) Public Debt Charges - is the amounts paid out each year by the federal government to cover the interest charges on its public debt.

11.2 Practise Questions 1. a) 1 million b) 0.33 c) 1/MPW 2. -

a) SM = 1.67, shift to left by 6667 -(MPC x change in T) x 1 / mpw b) SM = 1.25, shift to right by 6250 c) 3750 d) -66666.666667

Unit 3 - Fiscal Policy Page 3