The multipliers are calculated as follows:
Government expenditure multiplier = 1/( 1- MPC) or 1/MPS
Tax multiplier = -MPC/(1- MPC) or -MPC/MPS
- MPC is the marginal propensity to consume( the change in consumption divided by the change in disposable income) and MPS is the marginal propensity to save ( the change in savings divided by the change in disposable income).
- The Government spending multiplier is always positive. In contrast, the tax multiplier is always negative. This is because there is an inverse relationship between taxes and aggregate demand. When taxes decrease, aggregate demand increases.
- The multiplier effect of a tax cut can be affected by the size of the tax cut, the marginal propensity to consume and the crowding out effects.
- The multiplier effect is evident when the multiplier is greater or less than one.
Q1. Explain the likely effect of the value of the multiplier if there is an increase in the marginal propensity to consume (MPC)?
- The MPC + MPS = 1. Therefore if MPS = 0.18, then the MPC = 0.82.
- An increase in the MPC will lead to a fall in MPS.
- Example: MPC rises to 0.80 and therefore the MPS falls to 0.20
- The multiplier coefficient =1/ 0.2 = 5.
- An increase in the MPC raises the value of the multiplier.
Q2. An economy has a marginal propensity to tax of 0.3, a marginal propensity to import of 0.25 and a multiplier value of 1.25.
Calculate the value of the marginal propensity to consume (MPC)?
- The multiplier when there are three leakages: savings, taxation and imports.
- = 1/( the sum of the marginal rate of withdrawal from the circular flow).
- = 1/ (MPS +MRT +MPM)
- The multiplier = 1.25.
- Therefore 1.25 = 1/ MPS +0.3 + 0.25)
- Therefore (MPS +0.55) = 1/1.25 = 0.8
- Therefore MPS = 0.25
- If MPC + MPS =1, the MPC = ( 1-0.25) = 0.75.