Economics: Unit 3-Chapter 10: The Spending Multiplier

Consumption and Savings

Disposable Income (DI): Income after taxes or net income 

• DI = Gross Income - Taxes

With disposable income, you can either: 

• Consumer (spend money on goods and services)
• Save (not spend money on goods and services)

Consumption

• Households Spending
• The ability to consume is constrained by 
• The amount of disposable income
• The propensity to save
• Do households consume if DI is equal to 0?
• Autonomous Consumption
• Dissolving
• APC = C/DI, percent of disposable income that is spent

Saving

• Households NOT spending
• The ability to save is constrained by:
• The amount of disposable income
• The propensity to consume
• Do households save if DI = 0?
• NO
• APS = S/DI, percent that is not spent

APC and APS

The Average propensity to Consume/Save

APC + APS = 1

1 - APC = APS

1 - APS = APC

If APC is greater than I, than it is disaving

If APS is negative, then you are dissaving

MPC and MPS

Marginal propensity to Consume

• Change in Consumption/Change in Disposable Income
• The percent of every extra dollar earned that is spent

Marginal Propensity to Save

• Change in Savings/Change in Disposable Income
• The percent of every extra dollar earned that is saved

MPC + MPS = 1

1 - MPC = MPS

1 - MPS = MPC

Determinants of Consumption and Savings

• Wealth
• Expectations
• Household Debt
• Taxes

The Spending Multiplier Effect

The Spending Multiplier Effect: An initial change in Spending (C, Ig, G, or Xn) causes a larger change in aggregate spending or aggregate demand (AD)

• Multiplier = Change in AD/Change in Spending
• Multiplier = Change in Aggregate Demand/Change in (C, I, G, Xn)
• Why does this happen?
• Expenditures and income flow continuously which sets off a spending increase int he economy

Calculating the Spending Multiplier

• The spending multiplier can be calculated from the MPC or the MPS
• Multiplier  = 1/(1 - MPC) or 1/MPS
• Multipliers are positive when their is an increase in spending and negative when their is a decrease 

Calculating the Tax Multiplier

• When the government taxes, the multiplier works in reverse
• Why?
• Because now money is leaving the circular flow
• Tax Multiplier (note: its negative)
• -MPC/(1 - MPC) or -MPC/MPS
• If their is a tax-cut, then the multiplier is positive, because their is more money in the circular flow

Problem Solving Steps:

1. Calculate the MPS and MPC
2. Determine which multiplier to use and whether it is positive or negative
3. Calculate the spending and/or tax multiplier
4. Calculate the change in AD