The Multiplier Effect As you work through your AP Macroeconomics review, you ll find that the multiplier effect plays a vital role. The multiplier effect shows up in AP Econ in a few ways. In this post, you ll get a broad introduction to the multiplier effect, with a brief overview of the various ways you can expect to see it. Once you have a good understanding of the multiplier effect, be sure to check out our other posts on specific multiplier effects to fill in the details of your AP Macro studies! 96
Introduction First, we ll need to get a handle on some definitions that will be crucial in fully understanding the multiplier effect. The first definition that you ll want to know is the marginal propensity to consume (MPC). Let s say that you have a new summer job. This means you have a change in your disposable income, or the amount of money you have available after taxes. Then, the marginal propensity to consume is simply what fraction of that change in income you decide to spend. Likewise, the marginal propensity to save (MPS) is the fraction of a change in disposable income that you decide to save, or how much money you decide to save from your new job. These marginal propensities are the foundation for learning the multiplier effect for the AP Macro test and will show up in important equations once you dig deeper into specific multiplier effects. The Multiplier Effect The multiplier effect interacts with the economy exactly as the name would suggest: It multiplies the actions that, for instance, a government takes. Let s say the economy has gone into recession and the government wishes to create some new demand in the economy. For example, the government undertakes a large infrastructure project. The government spending, in this case, goes into the pockets of construction workers, who get income from working on the project. However, the economy is interconnected, and so the change in demand doesn t stop here! Instead, those construction workers will spend the money that they took home as income, buying all sorts of things like food, rent, and entertainment. People work in each of those industries, and so the spending of the construction workers becomes the income of workers in other industries. Likewise, their income will become the spending of still further people, and the cycle continues on and on. Aggregate demand has been stimulated further than just the initial money that was put into the construction project! How much demand is stimulated will depend on the marginal propensities to consume of the individuals in our economy. 97
What we ve just described is called the spending multiplier and is one of the various types of multiplier effects that you ll run into during your AP Macroeconomics review. There are other types of multiplier effects as well. The tax multiplier also effects the actions of fiscal policy, acting in the opposite direction of the spending multiplier. As you get taxed more, you have less to spend in the economy, and this means that there is less income available for workers at the places you usually spend your money! For monetary policy, there is also something called the money multiplier. You can learn more about each of these specific multiplier effects by moving on to on them while you study for AP Macro! While we won t go into the full details of these multipliers, there are a couple of equations for the multiplier effect that you ll want to know for your AP Macroeconomics review, and that we ll use as we work through a sample free response question. Specifically, you ll need a couple of equations to work with the spending multiplier and the tax multiplier. To calculate the spending multiplier, you just need to know the marginal propensity to consume. Though, of course, if you have the marginal propensity to consume, you know that the marginal propensity to save is just one minus the marginal propensity to consume. This is the case because you can only either spend or save your money! The spending multiplier is calculated as follows: The tax multiplier is calculated using 98
Why is the tax multiplier negative? Remember, while the government providing additional spending eventually multiplies into even more spending, taxes act in the opposite direction! When the government taxes you, that takes away some of the spending that you would ve done before the tax, but that spending was the income of one of that store s workers and they would have spent that money as well! In this way, government spending is multiplied to further increase demand in the economy, while additional taxes will multiply to drain even more demand out of the economy. With these equations and an understanding of the multiplier effect in hand, let s look at an example of what you can expect to see as an AP Macro free response question. Example Because you can find plenty more examples of free response questions in our other, more specific multiplier effect posts, we will just work through one question that asks you to use a couple of multiplier effects here. Specifically, the following question is pulled from the 2015 AP Macroeconomics Exam s free response questions: In this free response question, you are told that there is a recessionary gap of $300 billion and that the government would like to pursue a fiscal policy to close it. The marginal propensity to consume in this economy is given as 0.8. You are told that the government wants to only use spending to fully close the recessionary gap, and asked what the minimum amount the government can spend is. How would you start working on this question? Since you re asked how much the government needs to spend to close a recessionary gap, your first thought should be the multiplier effect! You know that the interconnectedness of the economy means that the government doesn t need to spend the full $300 billion to close that gap. Next, you know that if you need to calculate a multiplier effect, you ll need to know how much of the additional money gets spent by individuals in the economy. That is, you need to know the marginal propensity to consume! 99
Since the marginal propensity to consume is 0.8, you can now calculate the multiplier effect. Here, the marginal propensity to consume means that the multiplier effect is equal to 1/(1-0.8) = 1/0.2 = 5. So any spending that goes into the economy will be multiplied by 5. This means instead of needing a full $300 billion to close the recessionary gap, the government actually only needs to spend $300 billion/5 = $60 billion to close the gap. This is the minimum required change in government spending. Next, you are asked to consider what would happen if the government used tax cuts instead of government spending to boost the economy. You are asked whether the minimum required change in taxes to close the recessionary gap will be more, the same, or less than the required change in spending. First, you should remember that the sign on taxes is negative! This means that to stimulate the economy, the government needs to be cutting taxes! Once you know that, you can use the equation in the previous section to calculate the tax multiplier. Here, the tax multiplier is equal to 0.8/0.2 = 4. Where did the negative sign go? Again, you re reducing taxes, so the multiplier here is positive! The multiplier is smaller, so you know that you ll need more of a change in taxes to close the recessionary gap than if the government had used spending. Why is this the case? Because you ll save part of the extra income that you got from the tax cut! Conclusion In this post, you ve learned about the multiplier effect. The multiplier effect relies on the fact that everything in our economy is interconnected! Your spending is someone else s income, and their spending becomes another person s income! There are a few specific types of multiplier effects: namely, the spending multiplier, the money multiplier, and the tax multiplier. As you continue with your AP Econ studies, be sure to check our specific posts for each one of those types of multiplier effects! Can you think of other ways that the interconnectedness of our economy could lead to multiplier effects? 100