3.2 Multipliers

The Spending Multiplier

An initial change in spending causes a larger change in real GDP because one person's spending becomes another's income, which is partly re-spent. The spending multiplier = 1/(1-MPC) = 1/MPS. It shows how much total real GDP changes for a given change in aggregate demand (AD), such as a change in investment or government spending.

MPC and MPS

Marginal Propensity to Consume (MPC) is the fraction of extra income spent; Marginal Propensity to Save (MPS) is the fraction saved. They always sum to 1 (MPC + MPS = 1). A higher MPC means more spending is re-circulated each round, producing a larger multiplier and bigger shifts in AD.

The Tax Multiplier

The tax multiplier = -MPC/MPS, and is smaller in absolute value than the spending multiplier because a tax change first affects disposable income, and only the MPC portion is spent. Tax cuts increase AD (positive effect on spending), while tax increases decrease AD; the negative sign reflects this inverse relationship between taxes and consumption.

Key terms

Spending Multiplier formula

1/(1-MPC) or 1/MPS — shows how much real GDP changes for a given change in spending.

Tax Multiplier formula

-MPC/MPS — smaller in absolute value than the spending multiplier since only the MPC portion of a tax change is spent.

MPC (Marginal Propensity to Consume)

The fraction of an additional dollar of income that is spent.

MPS (Marginal Propensity to Save)

The fraction of an additional dollar of income that is saved. MPC + MPS = 1.

Why does the multiplier effect occur?

Because one person's spending becomes another person's income, which is partly re-spent, amplifying the initial change in spending into a larger change in real GDP.

Try an AP-style question

What is the spending multiplier?

1. 4
2. 0.2
3. 1.25
4. 5