Marginal Propensity To Consume and The Multipliers

The MPC and the Multipliers
First: the Spending Multiplier

(either investment spending or government spending)
Y = [ ? ] I
The MPC and the Investment Multiplier
If the investment community increases its
spending, incomes and consumption will
spiral upward in multiple rounds of earning
and spending.
Once the process has played itself out, the
economy’s equilibrium income will be
higher by some multiple of the initial
investment spending.
The 45-degree line represents all possible
income-expenditure equilibria: Y = E. (But,
of course, there is only one point along that
line that corresponds to full employment.)
Consumption behavior is given by a linear
equation C = a + bY. In this economy, the
slope “b,” also called the marginal
propensity to consume, is one-half, or 0.5.
Investment spending is added vertically to
consumption spending: C + I is total
spending for a wholly private economy.
The economy is settled into an initial
equilibrium where Y (measured
horizontally) is equal to C+I (measured
vertically).
Now suppose that increased optimism in
the business community causes
investment spending to increase by I .
The
Noteincreased investment
that the increase (I) causes
in income (Y) the
economy
appears totobe
spiral upward
about twice to
thea increase
new in
equilibrium, where the level of income is
investment (I).
higher by Y.
A second wholly private economy differs
from the first one only in terms of the
slopes of their consumption equations.
This second economy’s MPC is 0.8.
Notice that with a high MPC, this
economy is sensitive to even a small
change in investment spending.
Because
Note of this
that in the lessened
economy,attenuation
the increaseof in
the successive
income roundstoofbeearning
(Y) appears severaland
times
spending,
the increasetheinsmall I drives
investment (I).income up
by a substantial Y.
The consumption equation in this third
economy is almost flat. Its MPC of 0.1
means that people spend only one dime
out of each additional dollar that they
earn.
Only a very substantial increase in
investment can have an effect on income
comparable to that of the other two
economies.
The increase in income (Y) doesn’t
appear to be much larger than the
increase in investment (I). In the limiting
case, where MPC = 0, there is no
spiraling at all, and Y = I.
The MPC and the Investment Multiplier
More generally, the multiple that relates Y
to I is dependent on the MPC, which is
simply “b” in the equation C = a + bY.
We can actually calculate an

expression in the form of Y = (some
multiplier)I
Y = C + I, where C = a + bY
Eq. 1.: Y = a + bY + I
Suppose I changes by I such that Y
changes by Y. The new equilibrium is:
Eq. 2.: Y + Y = a + b(Y + Y) + I + I
Eq. 2.: Y + Y = a + bY + bY + I + I
Now, how do you find the difference between
Equilibrium 1 and Equilibrium 2?
Eq. 2.: Y + Y = a + bY + bY + I + I
Eq. 1.: Y = a + bY +I
Y = bY + I
Y - bY = I
(1 – b )Y = I
Y = [ 1/(1 – b )] I
Y = [ 1/(1 – b )] I
1/(1 – b ) is the investment multiplier.
We can say, then, that if investment spending
increases by I, then the equilibrium level of
income will increase by 1/(1 – b ) times that
increase.
100.00 100.00
80.00 180.00
Let the MPC be 0.80. 64.00 244.00
51.20 295.20
Suppose that investment 40.96 336.16
spending increases by 100. 32.77 368.93
26.21 395.14
By how much will income 20.97 416.11
increase? 16.78 432.89
13.42 446.31
That is, what Y is implied by 10.74 457.05
a I of 100. 8.59 465.64
6.87 472.51
5.50 478.01
Y = 1/(1-b) I
1/(1-b) = 1/(1-0.80) = 5
I = 100
Y = 5 (100) = 500
The MPC and the Multipliers
Second: the Tax Multiplier
(a head tax, which is a lump-sum tax)
Y = [ ? ] T
How do taxes affect consumption behavior?
For a wholly private economy:

C = a + bY
For a mixed economy:

C = a + b(Y – T)
“T” is a lump-sum tax, a head tax, a poll tax.

“(Y – T)” is after-tax income; it’s take-home pay.
Macroeconomists call it “disposable income”.
The MPC and the Tax Multiplier
As with the spending multiplier, the multiple

that relates Y to T is dependent on the
MPC, which is simply “b” in the equation C =
a + b(Y – T).
We can actually calculate an expression in
the form of Y = (some multiplier)T.
Y = C + I + G, where C = a + b(Y – T)
1.: Y = a + b(Y – T) + I + G
1.: Y = a + bY – bT + I + G
Suppose T changes by T, causing Y to change by Y.
The new equilibrium is:
2.: Y + Y = a + b(Y + Y) - b(T + T) + I + G

2.: Y + Y = a + bY + bY - bT -bT + I + G
Now, how do you find the difference between
Equilibrium 1 and Equilibrium 2?
2.: Y + Y = a + bY + bY - bT -bT + I + G
1.: Y = a + bY – bT +I+G
Y = bY -bT
Y - bY = -bT
(1 – b)Y = -bT
(1 – b)Y = -bT
Y = [ -b/(1 – b )] T
-b/(1 – b ) is the Tax Multiplier.
So, that if the tax take increases by T, the
equilibrium level of income will increase by -
b/(1 – b ) times that increase---which is to
say that income will decrease by b/(1 - b)
time the increase in taxes.
Compare Y = [ - b/(1 – b ) ] T
with Y = [ 1/(1 – b ) ] G
What’s the difference?

Which is bigger in absolute terms?
80.00 80.00
Let the MPC be 0.80. 64.00 144.00
51.20 195.20
Suppose that taxes are 40.96 236.16
reduced by 100. 32.77 268.93
26.21 295.14
By how much will income 20.97 316.11
increase? 16.78 332.89
13.42 346.31
That is, what Y is implied 10.74 357.05
by a T of -100. 8.59 365.64
6.87 372.51
5.50 378.01
Y = -b/(1-b) T
-b/(1-b) = -0.80/(1-0.80) = -4
T = -100
Y = -4 (-100) = 400
The Multipliers
}
Y = 1/(1-b) I
The Spending Multipliers
Y = 1/(1-b) G
Y = -b/(1-b) T
} The Policy Multipliers
Suppose we increase G by 100 and increase T by 100.
If b = 0.80, what will the net change in Y?
YG = 1/(1-b) G YT = -b/(1-b) T

1/(1-b) = 1/(1-0.80) = 5 -b/(1-b) = -0.80/(1-0.80) = -4
G = 100 T = 100
YG = 5 (100) = 500 YT = -4 (100) = -400
Y = YG + YT = 500 -400 = 100

When G = 100 and T = 100, then Y = 100.
More generally, when G = T, then Y = G = T.
Is this true for all values of b?
When b = 0.95, 1/(1-b) = 20; -b/(1-b) = -19
When b = 0.90, 1/(1-b) = 10; -b/(1-b) = -9
When b = 0.80, 1/(1-b) = 5; -b/(1-b) = -4
When b = 0.75, 1/(1-b) = 4; -b/(1-b) = -3
When b = 0.60, 1/(1-b) = 2.5; -b/(1-b) = -1.5
When b = 0.50, 1/(1-b) = 2; -b/(1-b) = -1
The Government Spending Multiplier and the Tax
Multiplier are always opposite in sign and always differ by
one in absolute terms.
The Balanced Budget Multiplier, then, is one.
Suppose that G and T change together--by (G&T).
Y = (spending mult.) (G&T) + (tax mult.) (G&T)
Y = (G&T)
Y = G = T

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The MPC and the Multipliers

First: the Spending Multiplier

We can actually calculate an

For a wholly private economy:

For a mixed economy:

“T” is a lump-sum tax, a head tax, a poll tax.

As with the spending multiplier, the multiple

2.: Y + Y = a + b(Y + Y) - b(T + T) + I + G

What’s the difference?

YG = 1/(1-b) G YT = -b/(1-b) T

Y = YG + YT = 500 -400 = 100

The Balanced Budget Multiplier, then, is one.

Suppose that G and T change together--by (G&T).

Y = (spending mult.) (G&T) + (tax mult.) (G&T)

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