Fiscal Policy WorksheetThe MultiplierAn initial change in any of the components of aggregate demand (AD) will lead to further changes in theeconomy and an even larger final change in real gross domestic product (GDP). That is, any initial change inspending will be multiplied as it impacts the economy. The final impact of an initial change in spending can becalculated using the spending multiplier. The size of the final impact of an initial change in spending on realGDP is affected by the amount of additional spending that results when households receive additional income,called the marginal propensity to consume, or MPC. The MPC is the key to understanding the multiplier, so thefirst step in understanding the multiplier is to understand the MPC.●The MPC is the change in consumption divided by the change in disposable income (DI).●The marginal propensity to save (MPS) is the fraction saved of any change in disposable income (DI).●Thus MPS + MPC = 1.Spending Multiplier = 1 / (1 - MPC) or 1 / MPS●How to use the spending multiplier:○Change in GDP = change in AD component X spending multiplier.●When to use the spending multiplier:○When there is a change in a component of AD (C,I,G,Xn).When the government changes taxes, it will also affect AD. If taxes are decreased, consumers (or businesses)have more disposable income and will increase spending. When the government raises taxes, households (orbusinesses) have less disposable income and will decrease spending. The basic multiplier effect is the same, butwith two differences. First, increasing taxes decreases spending, and decreasing taxes increases spending. Theeffect of taxes on spending is negative, so the tax multiplier has a negative sign. Second, taxes are not acomponent of AD. When taxes change, consumers (or businesses) will change their spending by only part ofthat amount, determined by the MPC. So, for every additional dollar in disposable income, spending will onlyincrease by $MPC. Therefore, the numerator of the tax multiplier is MPC, rather than 1.Student Alert:Make sure to use the tax multiplier when the change affecting AD is a change in taxes!Tax Multiplier = -MPC/(1 - MPC) = - MPC/MPS●How to use the tax multiplier:○Change in GDP = change in taxes X tax multiplier.●When to use the tax multiplier:○When there is a change in lump-sum taxes.Note: Remember that the tax multiplier has a negative sign.

1Calculate the Spending and Tax Multiplier for the following values: