Author:  Lori Alden

Audience:  High school and college economics students

Time required:  About 50 minutes

NCEE Standards:  18, 19, 20

Summary:  This activity helps students understand the simple Keynesian model of spending and output, the multiplier effect, and how government can affect GDP through fiscal policy.  

Theoretical backgroundKeynesian Theory in a Nutshell

Resources:   Click here to download 10 pages of materials.  Print the pages on 8 X 11 white cardstock.  (Note:  The materials are in pdf format.  To view them you'll need an Adobe Acrobat Reader, which you can download for free.)

Procedure:   Punch four holes each in the "Spending" and "Output" cards as shown below.  [Note:  Your text may use different terminology.  Instead of "Spending," you may want to use "Aggregate Demand," "AD," "Expenditures," "E," or "C + I + G + NX."  "Output" can be replaced with "Aggregate Supply," "AS," "Production," "GDP" or "Y."]

Thread a length of twine or cord through each of the cards and hang them vertically against a wall, blackboard or whiteboard so that the strings are taut and about 8" apart.  When the cards are at the same level, the Spending card should overlap the Output card so that the colored areas are completely covered.  

 

On one side of the strings, tape the "Spending < Output" and "Spending > Output" legends as shown below.  On the other side of the strings, tape the Inflation Zone, Healthy Economy Zone, and Unemployment Zone cards.  Cut the Event cards along the dotted lines and set aside.  

 

 

Demonstration #1:  Equilibrium in the Keynesian Model

Place the Spending and Output cards at the same level in the Healthy Economy zone, so that the Spending card blocks the colored region of the Output card.  Ask your students to assume the government increases spending and push the spending card up a few inches so as to reveal part of the green region.  

Explain that the increase in spending means that firms are now selling at a faster rate than they're producing and that their inventories are going down.  This tells firms to hire more workers and produce more output until output is once again in line with spending.  Show this response by pushing the Output card up so that it's again in line with the Spending card.

Observe that whenever the green area on the Output card is exposed, there's a "tendency to change," which means the economy isn't in equilibrium.  What's changing is that firms are losing inventories, leading them to produce more output. 

Hiring more workers to increase output causes further boosts in spending, in a chain reaction that economists call the "multiplier effect."  The workers that the firms hired increase their consumption spending, since their disposable incomes are higher.   This increase in spending causes firms to hire still more workers so that output once again matches spending.   The newly hired workers, in turn, increase their consumption spending, which leads to further increases in output, which led to more hiring, and so forth.

To demonstrate the multiplier effect, slide the Spending card and Output cards up several times in succession, so that the Output card appears to be trying to keep up with the Spending card.  Make each upward slide successively smaller so that the multiplier effect eventually peters out.  When you're done, the two cards should be even with each other.  

The diagram below shows how spending would continue to rise over several rounds if the multiplier equaled 4.  (Output, not shown, would passively rise each round to match spending.)

Here's how it would look if the multiplier equaled 2:

Also show what happens when the government cuts spending.  Slide the Spending card down a few inches, revealing the yellow region on the Output card.  

Explain that if spending is less than output, firms experience an increase in inventories, which leads them to lay off workers and decrease output.  Note that when the yellow region is exposed, there's once again a "tendency to change" in that firms are gaining inventories and trying to reduce output.  Show this response by sliding the Output card down until it's once again level with the Spending card.  This will launch a downward multiplier effect, since the laid off workers will cut back on spending.  Show this by sliding the two cards downward a few times in succession.

Demonstration #2:  What caused the Great Depression?

One likely cause is that firms became pessimistic and reduced their investment spending.  As spending went down, so did output.  To demonstrate this, start with both cards are the same level in the Healthy Economy zone.  Pull down the Spending card a few inches to show what happened when firms cut back on investment spending at the beginning of the depression.  Pull the Output card down to match it.

There was a multiplier effect, too.  As firms laid workers off, these workers cut back on consumption spending.  This reduction in spending caused output to fall and led to more workers losing their jobs, which led to further reductions in spending and output.   Show this by pulling the cards down several times in succession until they're both at the same level in the Unemployment Zone.

Demonstration #3:  Is there a cure for recessions or depressions?

If any of us were able to go back in time to the 1930s, we would have been able to tell FDR how to end the Great Depression--just increase spending.  Firms would have responded by stepping up production and hiring more workers.  The newly hired workers, in turn, would have spent more, leading to more output and even more spending. 

The government could have done this either by increasing government spending or by decreasing taxes, the two main tools of fiscal policy.  Of course, it would have been hard to convince people back then that this was the right thing to do.  Raising government spending while reducing taxes would have increased the federal budget deficit.  During the Great Depression, most people (incorrectly) believed that the federal budget needed to be balanced if we were to ever pull out of it.  

Demonstrate the effect of an increase in government spending by lifting up the Spending card a few inches so that part of the green region is exposed.  Pull up the Output card to match it.   Show the multiplier effect by pulling the cards up in succession for a few rounds. 

Demonstration #4:  Can we make GDP as large as we want?

By now, an exciting idea may have occurred to your students.  If we can control spending, why can't we make our nation's output as large as we like?  That way, everyone could live like kings and queens, with mansions, fancy cars, fine clothes, and gourmet food.

Unfortunately, this idea wouldn't work.  At some point, all of our resources would become fully employed in the production of output.  If spending rose beyond that point, output wouldn't be able to rise any further to match it.  Firms wouldn't be able to hire the labor, land, and capital needed to increase production.

That isn't to say we haven't tried.  In the late 1960s, for example, we increased spending to a level so high that output could not keep up.  The result?  Inflation.  When firms can't increase their output to match spending, they respond instead by increasing prices.  

Demonstrate this by placing both cards at the same level in the "Healthy Economy Zone."  Ask your students to assume that the government increased spending and push the Spending card up, then push the Output card up to match it.  Show the multiplier effect by pushing both cards up in succession for several rounds until both cards are in the Inflation Zone.

Classroom Drill

Distribute the event cards to students (or teams of students) and ask each in turn to come up to the front of the classroom and demonstrate how a given event will affect GDP in the first round (ignore the subsequent multiplier effects).  The first card, for example, says "The government increases defense spending in order to fight terrorism."  To demonstrate this, a student would push up the Spending card and then push up the Output card to restore equilibrium.  

 

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