MPC, MPS, and Spending/Tax Multiplier

Disposable Income

·         Income after Taxes or Net Income

·         DI= Gross Income- Taxes

Choices

·         With DI, Households can either

o   Consume (Spend money on Goods and Services)

o   Save (Not Spend money on Goods and Services)

Consumption

·         Household Spending

·         Ability to Consume is Constrained by

o   Amount of DI

o   Propensity to Save

·         Do Households Consume if DI= 0?

o   Autonomous Consumption

o   Dissaving

Saving

·         Household is NOT spending

·         Ability to Save is Constrained by

o   Amount of DI

o   Propensity to Consume

·         Do Households save if DI=0?

o   NO

APC and APS

·         APC= Average Propensity to Consume

·         APS= Average Propensity to Save

o   APC+APS=1

o   1-APC=APS

o   1-APS=APC

o   APC>1= Dissaving

o   –APS= Dissaving

Marginal Propensity to Consume (MPC)- Fraction of any change in DI that is consumed

·         MPC= Change in Consumption/ Change in DI

Marginal Propensity to Save (MPS)- Fraction of any change in DI that is saved

·         MPS= Change in Savings/ Change in DI

Marginal Propensities

·         MPC+MPS=1

·         MPC=1-MPS

·         MPS=1-MPC

Spending Multiplier Effect

·         Initial change in Spending Causes a larger change in AS or AD

o   Multiplier= Change in AD/ Change in Spending

·         Calculating the Spending Multiplier

o   Spending Multiplier can be calculated from MPC or MPS

o   Multplier= 1/(1-MPC) or 1/MPS

o   Spending Multipliers are positive when there is an increase in spending and negative when there is a decrease

Calculating the Tax Multiplier

·         When Government taxes, multiplier works in reverse

·         Why?

o   Because now, money is leaving the Circular Flow

·         Tax Multiplier is Negative

o   Multiplier= -MPC/ (1-MPC) or –MPC/MPS

·         If there is a Tax Cut, then the multiplier is positive, because now there is money going in the Circular Flow