Spending Multipliers

In this personal finance lesson, students will learn spending multiplier and the marginal propensity of consuming and saving.

• Activity 1, one copy cut apart
• Spending Multipliers PowerPoint Presentation | pdf file
• Activity 2, several copies cut apart
• Activity 3, one copy per student
• Activity 3 Key, Answer Guide
• 2 paper clips or tape
• Computer
• Computer projector
• Interactive, “Marginal Propensity to Consume/Save”

Consumer spending is always in the news, and almost all students hear information regarding it no matter how removed they are from political discourse. However, public understanding of consumer spending and the multiplier effect is poorly understood. Students will use their knowledge of ratios to analyze the marginal propensities to consume and save. The essential part of the lesson is when students use this knowledge to calculate spending multipliers for the economy. They see how changes in consumer spending influence economic growth or contraction of the economy. This lesson is designed for an Introductory Algebra course, and serves as a way to apply student knowledge of ratios to the real world.

1. Begin class by asking students what they would buy if they had $200. Ask a few students to share their responses and write them on the board.
2. Explain to students that whenever an individual has income, there are two decisions he or she can make: spend or save that income.
3. Define spending as using money to pay for goods or services. Define saving as keeping money for future use or diverting it into another form of investment.
4. Explain that an economy depends on a mixture of spending and saving.
5. Display Slide 1. Explain that economists use the marginal propensity to consume to measure the change in consumption as a proportion of change in disposable income. Disposable income refers to income after taxes have been paid. Note to teachers: for simplicity, we are ignoring taxes. A more sophisticated model would include tax and savings rates.
6. Display Slide 2. Explain that the marginal propensity to save tells economists what percentage of additional income individuals will save.
7. Display Slide 3 to show students the relationship between the marginal propensity to consume and the marginal propensity to save. Ask the following questions to check for understanding:
   1. How is the marginal propensity to save determined?
      [Subtracting the marginal propensity to consume from 1, or dividing the change in saving by the change in income.]
   2. If the marginal propensity to consume and the marginal propensity to save are added together, what is the mathematical result? [1]
   3. How are the marginal propensity to consume and the marginal propensity to save examples of ratios?
      [A ratio is the mathematical expression of a relationship between numbers. The marginal propensity to consume or the marginal propensity to save is an example of a ratio because the marginal propensity to consume expresses the relationship between extra spending (or saving) and extra income.]
   4. Are these slopes? [Yes.]
   5. How do these differ from the average propensity to consume (or save)?
      [The average propensity to consume (or save) is the percentage of income spent (or saved). The marginal propensity to consume (or save) is the extra amount of income spent (or saved) from each additional dollar of income received.]
   6. Could the marginal propensity to consume ever be greater than 1?
      [It is unrealistic for all consumers combined to have the marginal propensity to consume larger than one; however, the average propensity to consume could be larger than one. Remind students that individuals can borrow money or withdraw funds from their savings, so that people can actually spend more than their income.]
8. Explain that the marginal propensity to consume and the marginal propensity to save influence the economy through the multiplier effect.
9. To explain the concept, tell students they will be participating in a simulation. Choose two student volunteers to represent economic agents in the economy. Give one student the Family sign from Activity 1. Instruct students to paperclip or tape these signs to their shirts.
10. Tell students that the marginal propensity to consume in the economy is 8. Ask students the following questions:
    1. What does the marginal propensity to consume indicate?
       [It tells the amount of consumer spending which changes as a result of an increase in income. Students should be able to determine that it indicates that for every dollar income increases, spending increases by eighty cents.]
    2. What is the marginal propensity to save in this economy?
       [(.2) Students should be able to calculate this by subtracting the marginal propensity to consume from one.]
11. Let’s assume a family wants to buy art to hang on its newly painted wall. Have the student wearing the FAMILY sign use a check from Activity 2 and write it to a student for $100. Ask the student artist who received the $100 the following questions:
    1. What types of items would you spend the money on?
       [Answers will vary, but the student could spend it on any number of things from washing clothes to seeing movies.]
    2. How much money will the student artist spend on these items? [$80]
    3. How is this amount determined?
       [The marginal propensity to consume is .8, so the $100 of additional income multiplied by the marginal propensity to consume gives $80 of consumption spending.]
12. Have the student who received the $100 check spend $80 for services performed by someone else in the class. Using a blank check from Activity 2, have the student write a check for $80 to someone else in the class. Reinforce to students that this spending is directly tied to the initial spending of $100.
13. Ask the class what the student who just received $80 will do with the income.
    [Students should respond that the student can either spend or save it.]
14. Ask students the following questions:
    1. For each dollar this student received, how much will he or she spend?
       [80 cents]
    2. How did you derive this number?
       [The marginal propensity to consume is .8.]
    3. How much money will be spent in total by this individual?
       [$64]
    4. How did you calculate this number?
       [Multiplied $80 by the marginal propensity to consume.]
    5. What effect has the initial spending of $100 had on the economy?
       [The family spent $100. The first student received that $100 as income and spent $80. This provided income to another individual. This individual spent the income further increasing overall spending.]
15. Have the student write a check using a blank check from Activity 2 for $64 and give it to another student in the class.
16. Ask the class what the student who just received the $64 can do with the increased income.
    [Students should respond that he/she can either spend it or save it.]
17. Ask students the following questions:
    1. How much will be spent by this student?
       [$51.20]
    2. How did you calculate this number?
       [Multiplied $64 by the marginal propensity to consume.]
    3. What effect has the $100 initial spending had on the economy?
       [The initial person spent $100 and gave it to another student, who spent $80, which gave income to another individual. That person spent $64, who spent $51.20, further increasing overall spending.]
18. Now move on to a family who just had a new baby. Repeat steps 11-17 with that student, calculating the spending amounts with a new amount of money ($200) using a marginal propensity to consume of .9. Each time, students should write checks for other students in the class using a blank check from Activity 2. [Spending in each round should be: $200; $180; $162; $145.80]
19. Explain that the multiplier effect is the idea that a small increase in spending by consumers, businesses or government may cause larger changes in economic activity. Display Slide 4 to visualize the concept. Show students how initial spending can ripple through the economy as it flows to many other individuals and businesses.
20. Display Slide 5 and guide students through the example of the spending multiplier. Ask the following questions to check for understanding:
    1. What is the formula for the simple spending multiplier?
       [1/1-MPC or 1/MPS]
    2. How does the spending multiplier work?
       [As an individual or business spends, it creates income for someone else. With the additional income, the next person spends. His or her spending creates income for others and so on.]
    3. Why might the spending multiplier be less than expected?
       [Consumers save more than anticipated.]
21. Distribute a copy of Activity 3 to each student. Have students complete the practice problems. Use Activity 3 Answer Key to review the correct answers with students and correct mathematical errors.
22. Using a computer and projector, display the Marginal Propensity to interactive Consume/Save interactive (http://www.technology.councilforeconed.org/spending-multipliers/) onto the board.
23. Set the marginal propensity to consume to 10%. Ask the following questions to check for understanding:
    1. What is the simple spending multiplier?
       [.9]
    2. How much will the consumer (i.e. the one who received the $1000) spend?
       [$900]
24. Continue to use the interactive as a form of review, changing the ratios and allowing students to see how a change in the marginal propensity to consume affects the amount of spending in the economy.

1. Ask students to define marginal propensity to consume, marginal propensity to save, and simple spending multiplier.
   [Marginal propensity to consume measures the change in consumption as a proportion of change in disposable income. The marginal propensity to save tells economists what percentage of additional income individuals will save. The simple spending multiplier shows how spending by one economic agent flows to other agents throughout the economy.]
2. Display Slide 5 to review the formula for the spending multiplier.
3. Conclude by asking students why the spending multiplier is important for economic policymakers.
   [Students should state that the spending multiplier tells economic policymakers the approximate change in income that will result from an initial change. Emphasize that because income initially spent by people is given to other individuals who then spend a part of that income, the initial amount is magnified.]

1. Which of these describes the relationship between the marginal propensity to consume and marginal propensity to save?
   1. [The marginal propensity to save is derived by subtracting the marginal propensity to consume from 1.]
   2. The marginal propensity to save and the marginal propensity to consume are equal to the average propensity to save.
   3. The marginal propensity to consume is the ratio of the marginal propensity to save to total income.
   4. The marginal propensity to consume must equal the marginal propensity to save.
2. A consumer spends $200 on furniture for a new house. If the marginal propensity to consume is .5, which of these describes the effect on the economy?
   1. Expands by $100.
   2. Expands by $200.
   3. [Expands by $400.]
   4. Expands by $1000.
3. A recession strikes the economy and consumers spend $10 billion less than before. The marginal propensity to consume is .9. How will the economy be affected?
   1. Contract by $10 billion.
   2. Expand by $100 billion.
   3. [Contract by $100 billion.]
   4. Expand by $70 billion.
4. Imagine you are an Economic Analyst. According to data, the country is currently in a recession. You know that the marginal propensity to save in the country is .4. You would like to grow the economy by $70 billion dollars.
   1. What is the marginal propensity to consume in the country?
      [.6]
   2. How much initial change in consumer spending would result in $70 billion of total spending?
      [The spending multiplier is 1/MPS, or 2.5. To achieve $70 billion of economic growth, the spending would need to increase by $28 billion (70 divided by 2.5). That is, X*1/mps=$70 billion, X=$70billion/2.5; X=$28 billion]