JiTT - Fighting Recession: 2009

Contributed by Scott Simkins, North Carolina A&T State University

This material is replicated on a number of sites as part of the SERC Pedagogic Service Project

Summary

This is a JiTT exercise in which students apply introductory-level macroeconomic analysis to the question of how large the stimulus package put forward to Congress in early 2009 needed to be to close the recessionary gap facing the U.S. economy at that time. In particular, this exercise asks students to bring together the concepts of potential and actual GDP, recessionary gaps, fiscal policy, spending and taxing multipliers, and effects of changes in aggregate spending on employment and output.

Context:

This JiTT exercise asks students to apply and synthesize a number of macroeconomic concepts in a single context-rich problem that appears, at first glance, to be relatively large and unstructured. The underlying question is: How big did the fiscal stimulus package need to be to return the economy to full employment from a deep recession (depression)? The exercise is based on a New York Times essay by Paul Krugman published just before the inauguration of Barack Obama.

Learning Goals:

By the end of this JiTT exercise, students will be able to:

Apply multiple macroeconomic concepts to solve an unstructured problem.
Apply macroeconomic concepts to analyze political questions.
Analyze the linkage between macroeconomic policy actions and their impact on the economy.
Determine whether a given macroeconomic policy action is likely to solve the macroeconomic problem.

Teaching Notes:

Background Information

By January, 2009 the U.S. economy had been in a recession for over a year (the NBER dating committee determined in early December, 2008 that the recession began in December, 2007). Even in January, 2009 the recession was viewed as one of the most severe in U.S. history, precipitated by large-scale failures in the banking/finance system that led to restricted credit, widespread loss of jobs, and a precipitous decline in consumer spending and housing purchases, which increased in volume during the latter part of 2008.

The basic ideas presented in the underlying essay are part of the standard course content in macroeconomics courses at the undergraduate level, both at the principles and intermediate level. The JiTT exercise can be structured in a variety of ways, depending on the level of the course it is being used in. General examples are suggested below:

Principles-level course - In a principles-level course the instructor might summarize some of the information provided in the essay (estimates of potential GDP, actual GDP, multipliers, fiscal policy recommendations) and ask students to determine whether the recommended fiscal stimulus would be enough to close the recessionary gap and to explain the reasoning behind their answers. An additional question could ask students to list issues that might cause the ultimate fiscal stimulus package passed by Congress to be larger or smaller than that put forward by Barack Obama or that would cause the recommended package to over/under-shoot the mark. Some items mentioned in the essay: differences in effects of tax cuts and direct spending on output, concerns about resulting deficits, lack of ready-to-go investment projects, political caution.

Intermediate-level course - Students could be asked to obtain data on potential GDP and actual GDP and calculate the recessionary gap or alternatively, find Congressional Budget Office analyses with current values and future predictions of these measures. Students could then use more sophisticated multipliers drawn from their textbook reading to estimate the amount of fiscal stimulus that would be needed (perhaps what percentage would need to be in direct spending increases and what percentage in tax cuts) and determine whether the recommended stimulus package is large enough to close the recessionary gap.

When to use in the course - This exercise would most likely be used after students had covered the basic ideas of actual and potential GDP, recessionary gaps, fiscal policy, and multipliers. Typically this is toward the end of a standard macroeconomics course at either the introductory or intermediate levels.

Warm Up Question:

In early January, 2009 President-elect Barack Obama put forward a $775 billion stimulus plan intended to bring the U.S. economy out of a deep recession. According to economist Paul Krugman, about 60% of the Obama stimulus plan consisted of public spending on goods and services, the rest consisted of tax cuts. The nonpartisan Congressional Budget Office estimated that economic output would "average 6.8% below its potential" during 2009 and 2010. The CBO estimates of potential GDP (nominal) for 2009 and 2010 were approximately $15,280 and $15,655 (in billions of dollars). According to economists, a dollar of public spending raises GDP by around $1.50.

1. Was Barack Obama's stimulus plan too large, too small, or just about right to bring the U.S. economy out of recession? Explain the economic reasoning behind your answer.

2. After completing this exercise, what questions do you still have about this topic?

Variations for different level courses

Principles-level: provide estimates of actual and potential real GDP for 2009 and 2010 based on CBO analysis, along with public spending multiplier.
Intermediate-level: have students obtain GDP data and public spending/tax cut multipliers themselves.

Selected Student Responses:

The student responses selected for viewing in class (along with a brief explanation of why that response was selected) from a principles-level course are shown below. A broader set of responses can be viewed using the link below.

Student responses selected for showing in class:

I don't understand these issues even though I do understand the question and I do try to follow the economic debate in the press. Based on an interview with Paul Krugman I heard recently, the stimulus package is not big enough to close the recessionary gap.
Show reason for selection
This will put the economy in the hole so much that it wouldn't have any effect on the economy. This whole stimulus package is a bad idea.
Show reason for selection
Only 60% of the $775 billion stimulus package will increase GDP. Thus GDP will increase by $697.5 billion. Given that the forecast recessionary/contractionary gap is $900 billion, the stimulus package will/will not close the recessionary/contractionary gap.
Show reason for selection
We know that the change in GDP is the autonomous change in expenditure x the expenditure multiplier. We have to figure out how much Obama's stimulus package will change autonomous expenditures. The question says that 60% of the package is covering "public spending on goods and services." 60% of 775 is $465 and this would lead to a change in GDP of $697.50. This wouldn't be enough to close the gap. What impact will the change in taxes have? We don't know, therefore we don't really know if the plan will be big enough.
Show reason for selection

Show Full set of student responses.

I don't understand these issues even though I do understand the question and I do try to follow the economic debate in the press. Based on an interview with Paul Krugman I heard recently, the stimulus package is not big enough to close the recessionary gap.
This will put the economy in the hole so much that it wouldn't have any effect on the economy. This whole stimulus package is a bad idea.
Only 60% of the $775 billion stimulus package will increase GDP. Thus GDP will increase by $697.5 billion. Given that the forecast recessionary/contractionary gap is $900 billion, the stimulus package will/will not close the recessionary/contractionary gap.
We know that the change in GDP is the autonomous change in expenditure x the expenditure multiplier. We have to figure out how much Obama's stimulus package will change autonomous expenditures. The question says that 60% of the package is covering "public spending on goods and services." 60% of 775 is $465 and this would lead to a change in GDP of $697.50. This wouldn't be enough to close the gap. What impact will the change in taxes have? We don't know, therefore we don't really know if the plan will be big enough.
The government will raise taxes to pay for the stimulus package, so consumers and firms will reduce consumption and investment, canceling out the effect of the stimulus package.
The stimulus package would result in a decrease in GDP, thus increasing the output gap, because the tax effects outweigh the spending effects. Thus the Republicans are right that the spending is too much.
The stimulus package will actually have very little effect on the GDP because the increase in the deficit due to the increase in spending and decrease in taxes, will increase the interest rate and lead to a complete crowding out of private investment.
Given that the recessionary gap/contractionary gap is $2000 with the stimulus package of $775 billion and 1.5 multiplier, the stimulus will increase GDP by $1162 billion which is less than the recessionary/contractionary gap.
THE RECESSIONARY GAP IS MORE THAN $775 MILLION SO A $775 MILLION STIMULUS PACKAGE WOULDN'T BE ENOUGH TO GET TO POTENTIAL GDP.

Assessment of Student Responses:

It is useful to use the holistic grading rubric developed by Kathy Marrs (IUPUI) to assess student responses to JiTT questions. This rubric focuses on student effort and clarity of thought more than "correctness" of the answer. See Reviewing and Assessing Student Responses for Kathy Marrs' rubric and more information about assessing JiTT responses.

The Class that Follows:

In-Class Cooperative Learning Exercise

In groups, have students complete a cooperative learning exercise to break down this question into its component parts:

Determine the recessionary gap.
Use the provided multiplier to determine the output effects of the planned changes in government (public) spending.
Estimate how much overall spending would be increased by the planned tax cuts.
Determine the resulting overall estimated change in output due to the combined effects of the planned changes in government spending and planned tax cuts.
Determine whether the estimated change in output will close the recessionary gap.

Alternatively, you could ask students to list the steps necessary to come up with the answer to the JiTT exercise. The steps should look something like those listed above.

At the conclusion of the cooperative learning exercise - Have students report out and comment on differences, if any, in responses. If responses are similar (stimulus package too small), continue with extension 1, followed by a similar reporting out.

Extension 1: Have students determine how large the stimulus package would need to be to close the recessionary gap (this might involve differences in composition of the stimulus package between spending increases and tax cuts).
Extension 2: Compare different stimulus packages developed in extension 1 and their effect on future economic growth (e.g. effects on deficits, composition of spending on government "consumption" (health care?) vs. government "investment" (e.g. bridges, education).

References and Notes:

Paul Krugman, The Obama Gap, New York Times, January 9, 2009
Congressional Budget Office - The Budget and Economic Outlook: Fiscal Years 2009 to 2019, January 2009.