May 10, 2013
The Multiplier in Action
The impact of contractionary fiscal
Moody's Analytics estimates.
Chapter 12 Keynesian Economics: An Expanded View
Table of Contents
1. Average Propensity to Consume (APC) is consumption
(C) divided by income (Y).
a. APC = C/Y
b. APC decreases as income increases as people can
afford to save.
2. Marginal Propensity to Consume (MPC) is the change
in consumption divided by the change in income.
a. MPC decreases as income increases.
b. This makes sense because when an average is falling,
what is happening on the margin must be less.
1) Suppose your test average after one test is 90 and
after a second tests its 80. Your second test had to
be below 80 to pull the average down
Test 2 was a 70 and (90 + 70) / 2 = 80.
3. Saving (S) is income minus consumption. S = Y - C
4. Average Propensity to Save (APS) is S/Y
a. APS = S/Y
b. If APC drops as income increases, then APS increases
as income increases because APC + APS = 1
5. Marginal Propensity to Save is change in saving divided
by change in income.
a. MPS increases as income increases because wealthy
people can afford to save a higher income percentage.
b. This makes sense because when an average is rising,
what is happening on the margin must be higher.
6. Other factors affecting consumption and therefore saving
include wealth(savings), expectations about personal
needs and future economic activity, and concerns about
consumer, business, and government debt.
B. Investment is business spending on capital goods,
inventory, and research & development.
1. The level of investment is a function of expected profit,
interest rates, and the level of technology required to
maintain a desired competitive position.
2. Investment spending tends to be somewhat volatile.
C. Government Spending is assumed to be constant.
D. Net Exports, exports minus imports, are also assumed
to be constant for this simplified model.
Note: Points on a 45-degree line
Other Macro Chapters
8) Measuring Total Economic Activity
15) Monetary Policy
16) Stagflation & Supply-Side Economics
17) Budget Deficits See Democratic Capitalism vs Capitalistic Democracy
The savings decline is not a [problem because developing countries save
a substantial amount because unstable political systems mean they need
more protection form uncertainty. There precautionary motive is high.
One problem with this
simplified assumption is it assumes investment
is fixed. The following graph shows that it is not fined.
II. Aggregate Demand and Equilibrium
A. Equilibrium (E) is where planned and actual AD and AS are equal.
1. Equilibrium is where all goods produced for sale are sold.
2. At points below equilibrium, AD < AS, inventories are building and
business activity is contracting. This level of economic activity was
depicted by the horizontal (Keynesian) range of AS explained in the
3. At points above equilibrium AD > AS, inventories are decreasing and
business activity is expanding
as depicted by the intermediate range and eventually the classical
range of AS.
4. Economic activity (Real GDP) will be wherever AD intersects AS.
Equilibrium seldom exists as
economic activity is usually in one stage or another of the business
B. If economic activity is not in balance, a dynamic situation exists and
will continue until equilibrium is reached.
C. Keynes believed that E could settle at a level of economic activity with
large amounts of unemployment.
1. If potential Real GDP is greater than what actual AD yields, a reces-
sionary gap exists and may persist indefinitely. The solution to this
unacceptable equilibrium is to increase AD.
2. If potential Real GDP is less than what actual AD yields, an inflationary
gap exists and the inflation may persist indefinitely. The solution to this
unacceptable level of economic activity is to decrease AD.
3. Inflationary and Recessionary Gaps- ACDC Economics in 60 Seconds
D. Multiplier Affect (K) is important to determining the change in AD needed
to reach equilibrium E.
1. Changes in AD will result in larger changes in NNP as increases are not
spent and respent.
2. Decreases in AD have a similar but opposite affect.
3. K = 1/MPS = 1?(1-MPC) Note: As MPS increases, K decreases.
4. A MPS is 20%, Multiplier is 5 as 1/20% = 1/(1/5) = 1X 5 = 5
5. Fiscal policy and the multiplier... is an 9 minute video from youtube
III. Fine Tuning Economic Activity
A. When determining the required change in AD needed to achieve E, the Multiplier (K) concept must
B. This concept states that a change in AD will result in a larger change in Real GDP as these changes
multiply (are spent and re-spent or not spent and re-not spent) throughout the economy.
C. Saving will act as a leakage eventually stopping the change.
D. Suppose more is spent on investment and people receive this as income.
1. People receiving the income spend some (MPC) and save some (MPS)
2. A second group receives the spending of the first group as income and they also spend
some (MPC) and save some (MPS).
3. The process continues until savings eventually stops the progression.
E. Calculating multiplier (K), the multiple by which GDP will increase given some increase in AD.
1. K = 1 / MPS = 1 /(1 - MPC)
2. As MPS increases, K decreases
3. If MPS = 20% then 1/MPS = 1/.2 = 5
4. An increase of $100 billion in investment will result in 5($100) = $500 billion in new national
5. K = change in Real GDP / change in AD = 500/100 = 5
6. Some unpleasant Keynesian arithmetic Dank Rodrik
7. Multiplier Interactive practice problems from reff economics
F. Fed infrastructure spending has big multiplier 12/1/12 from econintersect
V. Additional Material
A. Maynard's Revenge: Keynesianism and the Crisis 1.05 hrs video, February16, 2010
B. Keynesian economics - Wikipedia
C. Review with information from the Institute for Economic Analysis
D. Are you a Keynesians Quiz begins with a review. 2/24/14
|Table of Contents||Economics Internet Library|