5 Steps to a 5 AP Macroeconomics 2019

Consumption, Saving, Investment, and the Multiplier ❮ 101

the circular flow. Using a spending multiplier of 5, if (X – M) = $10, GDP would increase

by $50.

Tax Multiplier

The preceding discussion of the public sector shows that when the government injects

money into the economy (G), it multiplies by a factor of the spending multiplier. But the

government can also have an impact on aggregate expenditures and real GDP by changing

taxes and/or transfers.

The Multiplier Effect

Recipients of a decrease in taxes treat it as an increase in disposable income. The typical

household increases consumption by a factor of the MPC and increases saving by a factor

of the MPS. It is important to keep in mind that less than 100 percent of this increase in

disposable income circulates through the economy because most households save a propor-

tion of it.

Example:

The MPC is equal to .90, and the government transfers back tax revenue to con-

sumers by sending each taxpayer a $200 check. With an MPC = .90, $180 is

consumed and $20 is saved. The multiplier process kicks in, but not on the

entire $200, only on the consumed portion of $180. The multiplier being

1/.10 = 10, GDP increases by $1,800.

In other words, a $200 change in tax policy (a tax rebate in this case)

caused an $1,800 change in real GDP. This tax multiplier of 9 measures the

magnitude of the multiplier process when there is a change in taxes.

The Difference in Multipliers

With an MPC = .90, the spending multiplier is 10, but the tax multiplier is smaller,

Tm = 9. Why? The spending multiplier begins to work as soon as there is a change in

autonomous spending (C, I, G, net exports), but the tax multiplier must first go through

a person’s consumption function as disposable income. In that first “round” of spending,

some of those injected dollars are leakages in the form of savings. In the example above,

10 percent of those injected dollars fail to be recirculated, and therefore the final multiplier

effect is smaller. The relationship between the spending multiplier and the tax multiplier

(Tm) is as follows:

Tm = MPC × (Spending multiplier) = .90 × (1/.10) = 9 in our example

Be prepared to respond to a free-response question that asks you to explain why the tax

multiplier is smaller than the spending multiplier.

Example:

The MPC = .80 and the government decides to impose a $50 increase in taxes.

What happens to GDP?

Tm = .80 × Multiplier = .80 × (1/.20) = 4

Because the tax multiplier is equal to 4, we determine that GDP falls by $200.

How do we know? Because taxes were increased, disposable income falls, con-

sumption falls, causing GDP to fall, in this case by a factor of 4.

KEY IDEA

TIP

“Remember that
taxes will have a
smaller multiplier
than government
spending!”
––Richard,
AP Student