Published on April 26, 2014
KEYNESIAN MULTIPLIER EFFECTS Let’s say you find a dollar in the street. You now have one dollar you did not have before. You now have an “income” of one dollar. What can you do with that dollar?? You can spend all of it, save all of it, or spend some of it and save some of it. You have options!
KEYNESIAN MULTIPLIER EFFECTS • Let’s assume you decide to spend the WHOLE dollar. Your spending of that dollar is an EXPENDITURE for you and INCOME for the person (entrepreneur) you traded with.
KEYNESIAN MULTIPLIER EFFECTS How much did GDP increase with this transaction? $1.00 (you bought “stuff”)
KEYNESIAN MULTIPLIER EFFECTS • Now what happens to that dollar in the possession of the entrepreneur? They have the same options you had: Spend it or Save it.
KEYNESIAN MULTIPLIER EFFECTS Let’s assume the entrepreneur spends the WHOLE dollar at another business. This expenditure for the entrepreneur is now INCOME for another entrepreneur.
KEYNESIAN MULTIPLIER EFFECTS How much did GDP increase with this transaction? $1.00 Does this sound familiar??
KEYNESIAN MULTIPLIER EFFECTS This “found” dollar has now purchased $2.00 worth of goods and/or services. The original dollar appears to be cloning itself!!
KEYNESIAN MULTIPLIER EFFECTS If we repeat this pattern, it would go on FOREVER and GDP would increase INFINITLEY. Is this possible? Unlikely…Why?
KEYNESIAN MULTIPLIER EFFECTS People have a TENDENCY TO SAVE some portion of each dollar they receive. Keynes had a fancy name for this: Marginal Propensity to Save (MPS). In layman’s terms this means people have a TENDENCY TO SAVE A PORTION OF EACH ADDITIONAL DOLLAR they receive.
KEYNESIAN MULTIPLIER EFFECTS The flip side of this is people have a TENDENCY TO SPEND (or CONSUME) some portion of each dollar they receive. Keynes had a fancy name for this: Marginal Propensity to Consume (MPC). In layman’s terms this means people have a TENDENCY TO CONSUME A PORTION OF EACH ADDITIONAL DOLLAR they receive.
KEYNESIAN MULTIPLIER EFFECTS • Example: If I get an additional dollar I may consume .90 and save .10. • My Marginal Propensity to Consume (MPC) that dollar is then: 90%. • My Marginal Propensity to Save (MPS) that dollar is then: 10%.
KEYNESIAN MULTIPLIER EFFECTS • Example: If I get an additional dollar I may consume .80 and save .20. • My Marginal Propensity to Consume (MPC) is then: 80%. • My Marginal Propensity to Save (MPS) is then: 20%.
KEYNESIAN MULTIPLIER EFFECTS Do you notice a pattern? MPC + MPS = 1.00 (or 100%)
KEYNESIAN MULTIPLIER EFFECTS • Let’s see how this works in practice. • Assume the Government wants to increase their spending by $10 billion dollars. Assume that the MPC in the economy is 90% and the MPS is 10% (remember these must equal 100%). What is going to be the effect on the GDP when we consider the Multiplier effect of EACH of those dollars?
KEYNESIAN MULTIPLIER EFFECTS • The Government initially spends $10 billion in the economy to purchase goods and services. Does the Government SAVE any of this money? NO. They spend the whole shebang! What is the immediate effect of this transaction on GDP? It INCREASES by $10 billion.
KEYNESIAN MULTIPLIER EFFECTS • What is now going to happen to that $10 billion now in the hands of people in the economy? Keynes says that people in general will spend 90% of it and save 10%. • So when people spend 90% of $10 billion, how much is GDP going to increase by? $9 billion.
KEYNESIAN MULTIPLIER EFFECTS • With these initial two transactions, how much has GDP increase by? $10B + 9B = 19B • Once again the original $10B has “magically” turned into $19B in GDP .
KEYNESIAN MULTIPLIER EFFECTS • Now when people who receive the $9B, they are going to spend 90%, or $8.1B and save 10%, or $900 Million. • GDP is now growing again! $10B + $9B + $8.1B = $27.1 Billion It does not stop here. Each time the money is spent it keeps reducing by the 90% and 10% ratio UNTIL it gets to ZERO and GDP is some much larger number.
KEYNESIAN MULTIPLIER EFFECTS • Do you want to do all that math to arrive at how much GDP is going to increase in the end. I did not think so. • Keynes came up with a simple formula to do the math for you. Remember in the beginning it was GOVERNMENT that started this buying frenzy. This is very IMPORTANT to remember.
KEYNESIAN MULTIPLIER EFFECTS TAX CUT MULTIPLIER •Instead of Government changing its spending, they could change TAXES instead.
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