Tutorial Topic: The Keynesian Model in Action 1.

During the Great Depression, Keynes argued that it would be better for the government to build pyramids than to do nothing. Do you agree or disagree? Explain. Agree. By building pyramids- the multiplier effect will take action starting from the government to the households, firms and so forth. This will cause a change in the GDP in comparison to just a stagnant economy if the government does nothing. 2. Suppose the economy is currently at equilibrium at an output level of $4,500 billion, and the MPC equals 0.90. For each of the following, determine the impact on the aggregate expenditure line and the equilibrium level of output. a. Government spending falls by $50 billion Spending multiplier = change in equilibrium real GDP/initial change in aggregate expenditure = 1/1 0.90 = 10 New equilibrium output = 4500-500 =4000 billion

b. Autonomous taxes increase by $50 billion

Ae falls by $50 billion. Tax multiplier = 1 1 /1 MPC = -9 Change in aggregate expenditure = -9 x 50 = -450 billion New equilibrium output = 4,500 450 = 4,050 billion

c. Exports rise by $10 billion

Change in aggregate expenditure = 10x10 = 100 billion New equilibrium output = 4500 + 100 = 4600 billion d. Interest rates fall and investment spending rises by $30 billion Change in aggregate expenditure = 30 x 10 = 300 billion New equilibrium output = 4500 + 300 = 4,800 billion 3. Suppose the MPS equals 0.25. The current real GDP is at equilibrium at $6,000 billion. Full employment would be experienced at an output level of $6,500 billion.

a. How much is the GDP gap? Is it a positive or a negative GDP gap? How much is the
recessionary or inflationary gap for this economy? GDP gap = actual real GDP full employment GDP = 6500-6000 = 500 billion Positive gap. Spending multiplier = 1/0.25 = 4 Recessionary gap = 500/4 = 125 billion 1

b. Would you recommend an increase or a decrease in government spending to eliminate

this GDP gap? How much should be the change in government spending? Increase in government spending to eliminate GDP gap by $125 billion. c. What change in autonomous taxes would you recommend to close this GDP gap? Decrease in autonomous taxes Tax multiplier = 1 -4 = -3 Change in autonomous taxes = 500/-3 = -$166.7 billion d. Sketch the Keynesian Cross diagram and locate these two gaps in your diagram. 4. Suppose the government wishes to eliminate a positive GDP gap of $100 billion and the MPC is 0.50. a. How much must the government cut its spending? Spending multiplier = 1/ 1-MPC = 1/1-0.5 = 2

b. Instead of decreasing government spending by the amount you have calculated, what
would be the effect on the GDP if the government had increased taxes by this same amount? Tax multiplier = 1-2 = -1 Decrease in real GDP = -1 x 50 = -50 billion c. Sketch the Keynesian Cross diagram and locate the positive GDP gap as well as the inflationary gap in your diagram.

Case Study Read the following article and discuss the economic implications of the Japanese earthquake disaster. What would be the effects on Japans real GDP? Be sure to highlight when the spending multiplier would be at work.

Japan says economy in "severe" condition No quick recovery in sight for triple disaster. -Reuters Fri, Apr 08, 2011 Reuters TOKYO - Japan's economy is in a "severe condition" with no quick recovery in sight following a triple disaster triggered by the March 11 earthquake that has sent service-sector sentiment plummeting the most on record, the government said on Friday. While Japan confronts the economic impact of the disaster, it also faces 2

increasing alarm from its neighbors with China expressing concern at the pumping of radioactive water into the sea from a crippled nuclear plant. China's Foreign Ministry said it would "closely" monitor Japan's actions to end the crisis at the plant, where engineers are battling to contain radiation leaks. It demanded accurate information from Tokyo. "As Japan's neighbor, we naturally express our concern about this," ministry spokesman Hong Lei said in a statement. China is the first nation to publicly express its concern over a crisis that has lasted close to a month. Other countries have banned or restricted food imports from Japan over radiation fears. "We ask that Japan reports the relevant information to the Chinese side in a swift, comprehensive and accurate way." Power blackouts and restrictions, factory shutdowns, and a sharp drop in the number of tourists have left the world's third largest economy reeling. Many economists expect it to slip into recession this year as factory output and exports suffer. The crippled Fukushima Daiicho nuclear power plant north of Tokyo means power shortages and supply disruptions that will leave the economy weak for some time, Japan's central bank said on Friday. The Cabinet Office's assessment was equally bleak. "Japan's economy is suddenly in a severe condition due to the effects of the earthquake," it said after releasing a monthly survey of hotel workers, restaurant staff and taxi drivers that showed a record fall in confidence to levels last seen during the depths of the global financial crisis. In an obvious sign of the downturn; taxis park in long lines in central Tokyo each night, their drivers staying warm by idling the motor as they wait forlornly for a fare. Japan is facing its worst crisis since World War Two after a 9.0 magnitude earthquake and a huge tsunami battered its northeast coast, leaving nearly 28,000 dead or missing and damaging six nuclear reactors north of Tokyo. The Tokyo area and regions further north make up half of Japan's economy, Nomura research shows. A strong 7.1 magnitude aftershock on Thursday night -- one of the biggest of more than 400 aftershocks above magnitude 5.0 -- shook the already ravaged northeast. It forced two companies, including electronics giant Sony Corp, to stop production due to power cuts. At least two people were killed after the tremor. There was a brief scare when water leaks were found on Friday at a second 3

nuclear plant, Onagawa, in the northeast, but Japan's nuclear safety agency said it had not detected any change in radiation levels. NO CHANGE IN RADIATION A relieved Tokyo Electric Power Co (TEPCO), which operates Fukushima, said Thursday's quake had not caused any more damage. It briefly evacuated workers because of a tsunami alert, although that was later withdrawn. The U.N.'s nuclear watchdog sounded an encouraging note when one of its officials said there were signs of progress in stabilizing the Fukushima plant, though the situation remained very serious. The International Atomic Energy Agency (IAEA) said it had not detected any change in radiation levels following Thursday night's quake. "The situation at the Fukushima Daiichi nuclear power plant remains very serious ... (but) there are early signs of recovery in some functions such as electrical power and instrumentation," the IAEA's head of nuclear safety, Denis Flory, said. The agency said radiation in the region around the plant, as measured by gamma dose rates, had peaked in the early days of the crisis, and aside from a rise on March 22, had since fallen to "a level very close to background." DISRUPTS BUSINESS Japan's neighbors have grown increasingly anxious at the risk of contamination from radiation, with some schools in South Korea closing because of fears of toxic rain. Officials there said the radiation levels in the atmosphere were harmless. China's health ministry said this week traces of radioactivity had been found in spinach in three provinces and the state news agency Xinhua reported trace levels of radioactivity detected in 22 provinces. To cope with power shortages, Japan's government has asked major companies to cut electricity use in the peak summer months by up to a quarter and the Tokyo Stock Exchange said the power cuts meant it would have to delay plans to extend trading hours. The impact of the quake meant both output and exports, major pillars of the economy, would remain weak, the central bank said. "Output will hover at a low level for the time being but then start to increase as supply constraints are mitigated," the Bank of Japan said in its monthly report for April. 4

Companies and households will need to cut back significantly on power usage this summer when demand is at its peak, Trade Minister Banri Kaieda said after a cabinet meeting. He urged major companies to cut electricity consumption by 25 percent. But some ministers at Friday's cabinet meeting called for an end to a campaign of "self restraint" by ordinary people that was adopted immediately after March 11 to cut fuel or electricity use and discourage stockpiling of necessities. "Some cabinet ministers said excessive self-restraint could worsen the economy, weakening economic power for reconstruction," Chief Cabinet Secretary Yukio Edano told reporters. PREVENTING MORE EXPLOSIONS Utility TEPCO said it was continuing to inject nitrogen into one of its Fukushima reactors to prevent a repeat of last month's hydrogen explosions. The plant is far from under control and engineers have been forced to pump in tons of water to cool down reactors, in the process making it radioactive. The water then has to be stored, though some has been released into the sea. Officials say it could take months to bring the reactors under control and years to clear up the toxic mess left behind. The government has set up a 20-km (12-mile) exclusion zone around the plant, banned fishing along much of the northeast coast and set up evacuation centers for the tens of thousands forced to leave their homes following the crisis.