Econ Exam - MPS = change in saving / change in income MPC +...

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MPS = change in saving / change in income MPC + MPS = 1 (MPS) Marginal propensity to save is the ratio of a change in saving to the change in income that brought it about. The proportion, or fraction, of any change in income consumed is called the marginal propensity to consume (MPC), “marginal” meaning “extra” or “a change in.” The MPC is the ratio of a change in consumption to a change in the income that caused the consumption change. An example can be used to make the concept clear. If a family earns the extra income of one dollar and if 0.45 is the value of marginal propensity to save, then according to the concept of MPS, the family will save 45 cents and spend 55 cents out of that one dollar. The inverse of marginal propensity to save theory is also true. It says that, a decrease in the income will result in the decrease of saving at the same proportion at which the income is decreased. The multiplier effect – more spending results in higher GDP; less spending results in a lower GDP. A change in spending, say, investment, ultimately changes output and income by more than the initial change in investment spending. That result is called the multiplier effect: a change in a component of total spending leads to a larger change in GDP. The multiplier determines how much larger that change will be; it is the ratio of a change in GDP to the initial change in spending. Multiplier = change in real GDP / initial change in spending Change in GDP = multiplier x initial change in spending If an investment in an economy rises by $30 billion and GDP increases by $90 billion as a result, we then know from our first equation that the multiplier is 3 (=$90/30). The initial change in spending is usually associated with investment spending because of the investments volatility. But changes in consumption on related to changes in income, net exports, and government purchases also lead to the multiplier effect. The initial change in spending associated with investment spending results from a change in the real interest rate and/or a shift of the investment demand curve. In the preceding point is that the multiplier works in both directions. An increase in initial spending may create a multiple increase in GDP, and a decrease in spending may be multiplied into a larger decrease in GDP. The multiplier process (MPC = .75) and the initial change in investment spending of $5 billion creates an equal $5 million of new income in round one. Household spends $3.75 (= .75 x 5) billion of this new income, creating $3.75 of added income in round two. Of this $3.75 of new income, households spend $2.81 (= .75 x $3.75) billion, and income rises by that amount in round three. Such income increments over the entire process gets successfully smaller but eventually produce a total change of income and GDP of $20 billion. The multiplier therefore is 4 (= $20 billion/$5 billion). Multiplier = 1/1-MPC
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This note was uploaded on 02/25/2009 for the course ACC 101 taught by Professor Fried during the Spring '09 term at Coastline Community College.

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Econ Exam - MPS = change in saving / change in income MPC +...

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