Friday, March 11, 2016

Spending Multiplier vs Taxing Multiplier

Spending Multiplier vs Taxing Multiplier


Multiplier formulas
Investment multiplier = 1/ (1-MPC) OR 1/ MPS
Spending or Government multiplier = 1/ (1-MPC) OR 1/MPS
Tax multiplier = - MPC x (1/MPS) OR - MPC/ MPS

2014 Macroeconomics #1 f

First, we need to understand the relationship between MPC/MPS. 
MPC is the marginal propensity to consume and the MPS is the marginal propensity to save.
Marginal meaning that it is the changes in income that are spent or saved.
If the MPC is 0.8, then 80% of a change in income will be spent,,, 
meaning that 20% will be saved. (MPS)

Expansionary Fiscal Policy
  • If the government increases spending by 100b then (GDP/AD/Incomes) will increase by the Spending Multiplier,, so,, 1/ (1-MPC) or 1/ (1-0.8)  = 1/0.2 = 5 x 100b = 500b increase in AD
  • If the government decreases taxes by 100b the (GDP/AD/Incomes) will increase by the        Tax Multiplier,, so,, -MPC/MPS,, so,, -0.8/0.2 = -4 x -100b = 400b increase in AD
  • Why the difference?? -  A tax decrease causes Disposable Income to rise,, but some that will be spent and some saved,,, while a increase in government spending is considered all spent.




Contractionary Fiscal Policy
  • If the government decreases spending by 100b then (GDP/AD/Incomes) will decrease by the Spending Multiplier, so, 1/ (1-MPC) or 1/ (1-0.8)  = 1/0.2 = 5 x -100b = -500b decrease in AD
  • If the government increases taxes by100b. (GDP/AD/Incomes) will decrease by the Tax Multiplier (hint: it is always 1 less than the Spending Multiplier),, so,, -MPC/ (1-MPC) or -80/ (1-0.8) or -80/0.2 = -4 x 100b = -400b decrease in AD
  • Why the difference?? - A tax increase causes disposable income to fall,, some of that tax increase will be paid out of savings.



Now,, 2014,, #1 f

If there is an equal increase in government spending and taxation will the Real GDP, Increase, Decrease or stay the same???

If the spending multiplier is 5 and increases government spending is 100b then 5 x 100b = 500b
If the taxing multiplier is -4 and government increases taxes by 100b then -4 x 100b = -400b

GDP would have increased by 500b + -400b = 100b


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