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Multipliers
Key Idea:
A small change in spending leads to a large
change in output/income
LRAS
PL
SRAS
PL1
AD
Y1
YF
GDP GAP
GDPR
• The difference
between Y1 and YF is
called the GDP GAP
• Do you need to spend
the whole amount of
gap to close the gap?
Key formulas:
• ∆ AE (C,I,G,XN) * M = ∆ GDP
• 1/MPS = M
• Tax multiplier
1-M
Practice Problems
• Suppose that autonomous consumption is
$400 and that MPC is 0.8. If disposable
income increases by $1,200, consumer
spending will increase by
a)
b)
c)
d)
e)
$1,600
$1,360
$1,200
$960
$400
Practice Problems
• In a closed economy with only lump-sum
taxation, if the marginal propensity to consume is
equal to .75, a $70B increase in government
spending could cause a maximum increase in
output of.
a)
b)
c)
d)
e)
$52.5b
$70b
$122.5b
$210b
$280b
Practice Problems
• If the MPC is 0.9, the government increases
purchases by $100, and net exports decline by
$60, the equilibrium level of real gross
domestic product will
a)
b)
c)
d)
e)
Decrease by up to $400
Increase by up to $400
Increase by up to $600
Decrease by up to $1,600
Increase by up to $1,600
Practice Problems
• If the federal government decrease its
expenditures on goods and service by $10b and
decreases taxes on personal incomes by $10b,
which of the following will occur in the short run?
a)
b)
c)
d)
e)
The federal budget will increase by $10b
The federal budget will decrease by $10b
Aggregate income will remain the same
Aggregate income will increase by up to $10b
Aggregate income will decrease by up to $10b
Practice Problems
• Assume that Jane’s MPC is 0.8, and that in 2004
Jane spent $36,000 from her disposable income
of $40,000. If her disposable income in 2005
increased to $50,000, her consumption spending
increased by
a)
b)
c)
d)
e)
$4,000
$8,000
$9,000
$10,000
$14,000
Practice Problems
• A high marginal propensity to consume
implies which of the following?
a) A small change in consumption when income
changes
b) A high savings rate
c) A high marginal tax rat
d) An equilibrium level of income near full
employment
e) A low marginal propensity to save
• 1. Assume the United States economy is operating at fullemployment output and the government has a balanced budget. A
drop in consumer confidence reduces consumption spending,
causing the economy to enter into a recession.
a)
Using a correctly labeled graph of the short-run Phillips curve, show
the effect of the decrease in consumption spending. Label the initial
position “A” and the new position “B”.
What is the impact of the recession on the federal budget? Explain.
Assume that current real gross domestic product falls short of fullemployment output by $500 billion and the marginal propensity to
consume is 0.8.
b)
c)
i.
ii.
d)
e)
Calculate the minimum increase in government spending that could bring
about full employment.
Assume that instead of increasing government spending, the government
decides to reduce personal income taxes. Will the reduction in personal
income taxes required to achieve full employment be larger than or smaller
than the government spending change you calculated in part (c)(i) ? Explain
why.
Using a correctly labeled graph of the loanable funds market, show
the impact of the increased government spending on the real
interest rate in the economy.
How will the real interest rate change in part (d) affect the growth
rate of the United States economy? Explain.