This document discusses the multiplier effect in economics. It defines key terms like disposable income, consumption, and savings. It explains that the marginal propensity to consume (MPC) measures how much of additional income is spent, while the marginal propensity to save (MPS) measures how much is saved. The multiplier effect occurs because initial spending, like from new investment, becomes income that is partially re-spent, creating more income and spending in a repeating cycle. The size of the multiplier depends on the MPC and shows how small changes in spending can amplify economic activity.

1. The Multiplier
“If you know how to spend less, you
have the philosopher's stone.”
-Benjamin Franklin

2. First , let’s define two terms
Disposable income is income you have left
over after you pay taxes.
That income is either spent or saved.
Dissavings is spending on goods and
services that exceeds disposable income.
Think of it as the opposite of saving – you are
spending more than you earn.

3. Let’s explore Consumption and Savings
Also note that
disposable
income equals
Consumption
plus Savings
(DI =C+S)
Imagine if you polled all households in our (hypothetical) economy and
determined what they plan to spend and save given various levels of income
Perhaps I could add all that information together to get the following table
describing the hypothetical economy we live in.
For example, if
our total
disposable
income were
$370 billion, we
may plan to
spend $375
billion.
In that scenario,
we would be
dissaving $5
billion…perhaps
because that
level of income
is low.
At higher levels
of income, our
spending and
saving would
increase!
If income were
$550 billion,
we’d spend
$510 billion and
save $40 billion.

4. So what causes us to spend and/or save?
In studying these decisions, we use the
term “Propensity”.
Propensity - a natural inclination or
tendency to do something.
For example, you might have a neighbor
that has a propensity to talk too much.
We’ll study two measures:
Marginal Propensity to Consume (MPC)
and
Marginal Propensity to Save (MPS)

5. Marginal propensity to consume and save
• Marginal propensity to consume
• Marginal propensity to save
The MPC measures the
share of NEW
disposable income that
you spend.
If your disposable
income increases by
$100 and you spend
$60 of that, then for you,
it is 60%.
The MPS measures the
share of NEW
disposable income that
you save.
If your disposable
income increases by
$100 and you save $40
of that, then for you, it is
40%.

6. MPC and MPS in tabular form
Notice: MPC+MPS always equals one or 100%.
There is no where else for this new income to go.
Examine the table and
ensure you understand
how the last two
columns were
calculated.
Notice that as income
increases from $370 to
$390…spending
increases from $375 to
$395
If income increases by
$20 billion, then
spending increases by
$15 billion. In other
words…75% of that new
income is spent.
And if the MPC is 75%,
the MPS must be 25%.
Check the math to verify
that this is true!

7. So… what causes us to spend and save?
Determinants of Consumption and Savings
• Wealth
– As households “feel wealthier”, they spend more
– This is a “Wealth Effect” such as the latest housing boom
• Expectations
– A future higher income may encourage a household to
spend more now
– Students typically accumulate debt with the belief that they
will pay it off later
• Interest Rates
– Higher rates encourage savings while lower rates
encourage borrowing
• Existing Debt
– High levels of debt may discourage dissavings
(HOPEFULLY!)
• Taxation
– Changes in taxation impact both consumption and saving
– For example: a tax cut would be partially consumed and
partially saved

8. Let’s practice: Try filling in these blank
cells…then click to see the answers

9. So why do we care about all this?
So why do we care? Because small changes in
our propensity to spend can have BIG changes
in overall economic activity.
This idea is known as the multiplier effect.
$ $ $ $$
Let’s start with is a reason why this is important, then spend
a few slides applying it.

10. The multiplier effect at work
Keep in mind
that this also
works in
reverse!
Assume the MPC is 0.75
Let’s say interest rates
fall, encouraging more
investment.
Some of that income is then
re-spent. In this case, it is
75% of it. (MPC=0.75)
The re-spent money
becomes someone else’s
income.
And this process goes
around and around…
Note that $5 billion in
new investment has
created $20 billion in
economic activity!
Perhaps you decide to
build a new factory
costing $5 billion.
That investment then
becomes someone’s
income.

11. Calculating the multiplier
Each of these formulas can
give us the multiplier
For example, the initial
impact in the previous
example was $5 billion.
That resulted in an overall
impact of $20 billion…the
multiplier is 4!
In the previous example the
MPC was .75. We spend
$75 out of every $100 in new
income.
If that is true than
1/(1-MPC) = 1/(1-.75) =
1/(.25)…
Which is 4!
In the previous example the
MPC was .75. If that is true,
then the MPC must be .25.
If that is true than
1/.25=4!

12. Here is where it get’s REALLY important
Imagine we live in an economy
where the MPC is 0.75.
The multiplier there would be 4.
And any new dollar in spending
that occurred would turn into $4
in economic activity.
Now imagine we start shopping more
and the MPC goes from 0.75 to 0.8.
When that happens, the multiplier
would increase to 5!
And any new dollar in spending that
occurred would turn into $5 in
economic activity.

13. Use this multiplier exercise to ensure
that you understand
If the MPC is 0.5 (50%), the
multiplier is:
If the MPC is 0.9 (90%), the
multiplier is:
If the MPS is 0.25 (25%),
the multiplier is:
=2
=10
=4

14. In summary
Therefore initial increased spending (from the
construction of a factory for example) can have
large impacts on overall economic activity.
Any new spending in our economy is
multiplied as consumers re-spend
portions of their new incomes.
That re-spending is referred to as the
multiplier effect.
The size of the multiplier effect is determined by
consumer behavior – specifically how much
people re-spend (their MPC).
In an economy with a high MPC, an initial spending
change such as a new investment will be multiplied as
that spending ripples through the economy.