MAcro CHAPTER 3.2:

CHAPTER SUMMARY

Every time someone earns a dollar, they have two options for what to do with it: spend it or save it. Most people, when they earn more money, will do some of both - they spend some of it and save the rest. When your income increases by $1, the number of cents you would choose to spend is known as your marginal propensity to consume (MPC). The number of cents you would choose to save is known as your marginal propensity to save (MPS).

I am pretty careful with my money, so if my income increases by $1,000 this year, I would probably spend an additional $200 and save the remaining $800. This means my MPC is 0.2 and my MPS is 0.8. This is a pretty simple concept, but here are the formulas for each, just in case:

MPC = Change in spending / change in income MPS = Change in saving / change in income

MPC + MPS always has to equal 1, because spending and saving are the only two things I can do with my money.

When I spend my money, though, it doesn't just disappear. When I spend money, it increases someone else's income, which means they have to choose how to spend and save that money I paid them. Let's imagine that everyone is just as careful with money as I am and see what happens.

I received that $1,000 in income, and spent $200 of it, so the total increase in spending so far is $200. Someone else received that $200, and they spent 20% of it as well, because they also had an MPC of 0.2, meaning they spend $40. Now that total spending increase in our economy is $200 + $40 = $240. Someone else received an additional $40, and spend $8 (20%) of it, so now the total spending if $248. Eventually, the total increase in spending in this economy as a result of my $1,000 increase in income is $250. This means that, if the government had given me the initial $1,000, the actual increase in economic activity is $1,250 as a result. Money pumped into the economy gets multiplied, which is why we call this the multiplier effect.

The multiplier effect of some initial amount of spending is pretty easy for governments and economists to predict, if they know the MPC and MPS of a whole economy. Each person is different, but if we know the average MPC and MPS for an economy, then we can use the formula 1/MPS to calculate the spending multiplier. For example, if I know the MPS is 0.25, then the spending multiplier is 1/0.25 = 4, so if the government spends $1,000,000 on a project, they can expect that this will result in a total increase in spending in the economy of $4,000,000. The chart below has some examples of different initial changes in spending and the resulting change in economic activity.

In addition to increasing or decreasing spending, governments can also influence the economy by changing the amount of tax they collect. The impact of a change in taxes is known as the tax multiplier.

The tax multiplier is always smaller than the spending multiplier. This is because, if the government spends $10 billion in an economy where MPC = 0.5, then spending has increased by $10 billion, then another $5 billion, then another $2.5 billion, then $1.25 billion and so on, as a result of the multiplier effect. However, if the government lowers taxes by $10 billion in that same environment, people will save half of that money instead of spending it, so we only see an increase in spending of $5 billion, then $2.5 billion, then $1.25 billion, and so on.

The formula for the tax multiplier is -MPC/MPS. MPC is negative because increasing taxes lowers spending and lowering taxes increases spending. If MPC and MPS are both 0.5, that means the tax multiplier is -1, so raising taxes by $10 billion would decrease total spending in the economy by $10 billion. However, if MPC is 0.8 and MPS is 0.2, then raising taxes by $10 billion would decrease total spending by $40 billion, because -0.8/0.2 = -4, meaning there is a tax multiplier of -4. On the flip side, lowering taxes by $10 billion would increase spending by $40 billion in this same economy.

If you're finding that tax multiplier calculation hard to remember, here's a little trick: the tax multiplier is always the opposite of the spending multiplier, plus one. If the spending multiplier is 10, the tax multiplier is -9. If the spending multiplier is 100, the tax multiplier is -99. This works unless you are calculating a fringe situation like MPC = 1 or MPC = 0.

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