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### Course: AP®︎/College Macroeconomics>Unit 3

Lesson 2: Multipliers

# MPC and multiplier

The expenditure and tax multipliers depend on how much people spend out of an additional dollar of income, which is called the marginal propensity to consume (MPC). In this video, you'll explore the intuition behind the MPC using a simple economic example, and will learn how to use the MPC to calculate the expenditure multiplier. Created by Sal Khan.

## Want to join the conversation?

• 1. Is having a high MPC is always a good thing for the economy?

2. Can MPC be influenced by monetary or fiscal policies? In other words, how can we increase or decrease MPC?
• MPC can be influenced by the policies in a country because of what is called MPS, Marginal Propensity Save. using the example of MPC as 60% or 0.6, MPS would be 40 or 0.4 whereas MPS is affected by policies that aim to either increase or reduce the people's saving habits
• I don't understand, wouldn't the \$1000 eventually be used up?
If you use 60% of it, then I use 60% of what you pay me, then you use 60% of what I gave you, wouldn't someone eventually run into negative numbers AKA debt? Thanks ahead of time. :)
• Well, no, if you try to calculate that to infinity, somewhere along that line, someone will not receive anything. And you can't lend "nothing". That's where the Multiplier effect ends.
• At the end of the video sal says if you spend an extra dollar in the economy givin the MPC thats what the total output would increase. But how does this plug back into Y=C+I+G+NX? Does this mean if we spend an extra \$1000 that Y would go up \$2500?
• The C+I+G+NX is a short form of an expanded equation. Just considereing C,
Total C actually = Co + c (Y-T) where Y-T is your disposable income ie income after tax.
Thus part of consumption (Co) does not depend on income and part of it does c Y.
c is the marginal propensity to consume. c = delta C/delta Y. It tells us how much Consumption will change for a given change in income eg if income (Y) rises by \$1 and total Consumption changes by 60 cents then c = .6.

The reason you cant see where it plugs back in is because you are not looking at the expanded equation. If we plug it back in properly the equation becomes

Y = Co + c(Y-T) + I + G + NX.
Note - the equation is capable of being expanded further depending on assumptions eg NX may not be all exogenous and nether might tax (in fact part of total taxes commonly depends on income and part does not ie total T = non income taxes plus income taxes = To + tY

You can see using the expanded equation that if c=.6 and the change in Y is plus 1000 then initially the Y on the left side would grow by 600 but we need to then add that 600 to the Y on the right hand side so there will be further increases due to the feedback loop in the equation.
The final change in Y = 1/1-c X 1000 = 1/1-.6 * 1000 = 2500

(assuming that t = 0 ie there are no income taxes which will reduce the final change)
• If the multiplier is 1/(1-MPC)
With an MPC of 0.8 (saving 20% of your income), this would yield a multiplier of 5. But this is way too high; most estimates of the keynesian multiplier are under 2. How can this be?
• At a basic level, the multiplier is taught as 1/(1-mpc). However, there are actually more components that go into it, which reduce the multiplier.
• How does inflation factor into this? I imagine that since the builder and the farmer are getting paid more, they're also producing more. But isn't there a point at which the farmer or the builder decides that prices are too high and that s/he should wait until they drop, lowering his/her MPC?
• That is simply an exogenous shock and exogenous shocks can be unpredictable. What we can predict is the effect on Y after the shock. If the farmer decides to stop spending and wait for prices to fall, then he will reduce either his exogenous consumption (Co) or his Investment (I) typically. In either case Y will fall by 1/1-c * the change in either Co or Io
(the o subscript indicating that the variable is independant of income ie that part of either the builder's or the farmer's spending that is not determined by his income. In the example you gave it is determined by price ie they are waiting for the prices to drop).

Of course the farmer and builder may also decide to lower the proportion they consume at every income level (c) and raise the proportion they save of their income (whilst waiting for lower prices). In this case the c would fall and 1-c (marginal propensity to save) would rise.
• While the \$1,000 end up creating \$2,500 worth of transactions in the economy don't you end up with an economy within which there's no money left to buy goods and services because each party is holding funds?
• This is where the Federal Reserve and the fractional banking system play a role in the economy. The money supply is changed according to demand and banks can loan a certain portion of their reserves according to the set reserve requirements.
• Okay so how come the answer is 2500 and not 2305.60?
When using the equation:
1000 + 0.6*1000 + 0.6^2*1000 + 0.6^3*1000 +0.6^4*1000
=2305.6
• Because you don't really stop at the fourth power. You keep going until you've run out of money.
• Does the MPC "keep going forever" or eventually stop? Especially since this is such a simple economy.
• To facilitate a growing economy you need a growing money supply. The Federal Reserve in the United States controls the supply of money to banks; banks loan money to individuals and companies for consumption and investment.
(1 vote)
• If any increase in Y is divided in consumption and saving, and saving equals to investment. Then if there is an increase in spending, besides the additional consumption caused by MPC, should the saved part also goes into investment and then also increase people's income and then continuous cycle??