What this lesson teaches
I can explain how a change in AD has a multiplied effect on national income.
Syllabus 9570, 3.1.2(e). Aggregate Demand and Aggregate Supply: How changes in the components of AD can have a multiplied effect on national income
Make a guess
For each extra $1 of income, people pay $0.10 in tax, save $0.20 and buy $0.10 of imports. How much is spent on local output?
- $0.40, the total withdrawn.
- $0.60.
- $0.70, everything not taxed or saved.
Show the answer
$0.60.
Each extra dollar is either spent on local output or withdrawn. Withdrawals are 0.1 + 0.2 + 0.1 = 0.4, leaving 0.6 for local output.
Marginal propensities show how each extra dollar of income is split between spending, saving, tax and imports.
The marginal propensity to consume (MPC) is the share of an extra dollar of income that is spent. The marginal propensity to save (MPS) is the share saved.
In an open economy with a government, part of each extra dollar also goes on tax (MPT) and imports (MPM).
Each extra dollar ends up either spent on domestic output or withdrawn: MPCd + MPS + MPT + MPM = 1, where MPCd is the share spent on domestic output.
The withdrawals together are the marginal propensity to withdraw: MPW = MPS + MPT + MPM.
- MPW
- MPS + MPT + MPM.
- Identity
- MPCd + MPW = 1.
Worked example: Splitting an extra $100
For every extra $100 of income, households pay $10 more tax, save $20 and spend $70: $60 on local goods and $10 on imports.
- MPT = 0.1, MPS = 0.2, MPM = 0.1.
- MPC (all consumption) = 0.7; MPCd (local only) = 0.6.
- MPW = 0.2 + 0.1 + 0.1 = 0.4.
- Check: MPCd + MPW = 0.6 + 0.4 = 1.
Watch out for this
MPC + MPS + MPT + MPM = 1, using total consumption.
Total consumption already includes imports. Use domestic consumption (MPCd) in that sum, or imports are counted twice.
Check your understanding
MPCd is 0.45, MPS is 0.2 and MPT is 0.15. What is MPM?
- 0.2, since the four shares must add up to 1.
- 0.35, the sum of the saving and tax shares.
- 0.8, the sum of the three shares that are given.
Show the answer
0.2, since the four shares must add up to 1.
Right. MPCd + MPS + MPT + MPM = 1, so MPM = 1 - 0.45 - 0.2 - 0.15 = 0.2.