Practice
Spending and tax multipliers
The marginal propensity to consume, the spending and tax multipliers, and how far a change in spending or taxes moves aggregate demand.
The skill
A change in spending gets multiplied because each dollar spent becomes someone's income, and they spend the MPC share of it. The spending multiplier is 1 divided by the MPS, and the MPS is 1 minus the MPC. A tax change starts smaller, since households save part of it, so the tax multiplier is the MPC divided by the MPS and works in the opposite direction. Students most often divide by the MPC instead of the MPS, or apply the spending multiplier to a change in taxes.
A worked example
In an economy, households spend 60% of every additional dollar of disposable income and save the rest.
What is the government spending multiplier?
Solution
- MPC = 0.6, so MPS = 0.4.
- Spending multiplier = 1 ÷ MPS = 1 ÷ 0.4 = 2.5.
- Each dollar of new spending becomes someone’s income, and they spend the MPC share of it, and so on; the multiplier is the total of all those rounds.
Answer: 2.5