Reflective Exercise: The London Olympics - how will the economy be affected?
1
What is the effect of the London Olympics on the Economy?
The Scenario
The London Olympics in 2012 will involve government expenditures, including that on
new stadia, and this will be financed from various sources including an increase in
council tax. In this exercise we will examine the effects of these fiscal changes,
concentrating first on the effect of the government expenditure change. Other
changes may also be involved, but we will limit ourselves to these effects at present.
Section 1: Setting the framework for investigating this question
How would an economist approach this question? (You will be expected to use
information gained to answer later questions.)
A
a
b
c
Tick however many of the following you think appropriate.
We treat the particular expenditures and taxation just as
‘government expenditure’ and the ‘taxation’ in our analysis,
without referring to the details in this case.
We need to consider the particulars of these expenditures and
taxation as they are for a unique event.
We consider the detailed impact of the Olympic Games, how this
will affect local communities and finally how this interacts with
more national concerns.
feedback page 5
B Tick however many of the following you think appropriate
We will start by assuming equilibrium in the economy and trace
changes through to another equilibrium
b We will start by assuming equilibrium in the economy and consider
the movement to disequilibrium.
c We shall start with disequilibrium and consider moving to
equilibrium.
feedback page 5
a
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This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
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Reflective Exercise: The London Olympics - how will the economy be affected?
C
a
b
c
d
e
f
2
Tick however many of the following you think appropriate
When considering the effect of the increase in government
expenditure we shall examine what happens to withdrawals to the
circular flow.
When considering the effect of the increase in government
expenditure we shall examine what happens to injections and
withdrawals to the circular flow.
When considering the effect of the increase in government
expenditure we shall examine what happens to injections in the
circular flow, not withdrawals.
The increased government expenditure will stimulate employment,
consumption and imports.
The increased government expenditure will switch consumption
away from other things and so there will be no overall effect.
The increased government expenditure will increase incomes,
which increases consumption and output, this then increases
incomes, consumption and employment again and this continues
without limit.
feedback page 5
Copyright: Embedding Threshold Concepts Project
05/09/08
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: The London Olympics - how will the economy be affected?
3
Section 2
(a) What is the effect on the economy of the increased government expenditure in
preparation for the London Olympics in 2012?
(b) If this increase in government expenditure is financed by an increase in the
council tax, does this mean there will be no overall effect?
Use the aspects we have explored in section 1 in answering this question.
You should illustrate your answer with a diagram.
Your answer…..
You can continue your answer on another sheet if needed…
feedback page 6 or 9
Copyright: Embedding Threshold Concepts Project
05/09/08
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: The London Olympics - how will the economy be affected?
4
Follow up questions:
1.
The London Olympics will lead to a large number of foreign visitors to the
Games. What will be the effect of this on the economy?
2.
London already has close to full employment. Is this likely to change any
of your conclusions?
3.
If the tax raised depends on income, how does this affect your answer?
Copyright: Embedding Threshold Concepts Project
05/09/08
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: The London Olympics - how will the economy be affected?
5
Feedback Section 1: Setting the framework
Now review your answers in the light of the economist’s approach below. Were your
answers the same? If not, why not?
A
An economist would be concerned with changes in total (or aggregate)
expenditure and output (production) resulting from government expenditure on the
Olympic Games.
They would start from considering a model of how government expenditures and
taxation affect the economy. They would not start from considering the particulars
of the event as these details may obstruct our understanding of basic processes.
Thus (a) is correct, not (b) and (c). This approach is seen as simpler and may lead us
to stress important relationships. It will help us ‘see the wood from the trees’.
B
(a) is the correct answer.
Equilibrium is where the economy is in balance and there are no forces at work
leading to further changes. This is where injections equal withdrawals or equivalently
where planned income = planned expenditure.
We start from equilibrium and consider the movement to another equilibrium. This is
not because we think that the economy is always in equilibrium: it is because the
economist considers that in disequilibrium there will be forces at work to push us
towards the equilibrium. In this example the withdrawals will increase/decrease
automatically as income increases/decreases in a way that restores equilibrium, as
we will consider further in part C.
Thus if we want to consider the full impact of a change in the economy we have to
consider the movement from an original to a new equilibrium.
C
It is important to think here in terms of a model of the economy. The increase in
government expenditure is an injection of expenditure into the economy (increase
aggregate demand) and this will lead to increased employment from the projects
and hence increased incomes. Some of this increase in incomes will be spent on
consumption and some go on withdrawals – some will be saved, some will be taxed
and some will be spent on imports. Thus (b) is correct and not (a) or (c).
The increase in consumption will further increase output and incomes, but by a
decreased amount because of the increase in withdrawals. This multiplier process
continues until we are back in equilibrium where injections = withdrawals or
equivalently where planned income = planned expenditure. Thus (d) is correct, but
(e) and (f) are not.
Copyright: Embedding Threshold Concepts Project
05/09/08
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: The London Olympics - how will the economy be affected?
6
Feedback Section 2: The approach of economics
(intermediate)
The question suggests the use of a diagram. What diagram?
The diagram(s) to be used in your answer depends to some extent on what you
have covered in your course. There are several related diagrams that can be used.
You could use:
(i)
The circular flow diagram – this shows the injections and withdrawals, but
does not fully illustrate the multiplier effect.
(ii)
The Keynesian cross diagram. This illustrates the changes in expenditure
and tax and the multiplier effect.
(iii)
The injections/withdrawals diagram. This illustrates the changes in
expenditure and the multiplier effect and is essentially the same as (ii).
(iv)
The IS-LM diagram. In this the IS curve will shift by the final increase in
expenditure (including the multiplier effect – but it does not show the
multiplier effect separately).
(v)
The AD/AS diagram. In this diagram the aggregate demand curve will
shift, but it shows the final effect of the expenditure change on aggregate
demand. It does not show the multiplier effect separately.
Either (ii) or (iii) most fully illustrate the changes here. However, it is also important
to realise how these effects are transmitted through the economy in the more
complicated models in (iv) and (v). We illustrate (ii) below.
Did you label the
axes correctly?
E
Did your expenditure lines
slope upwards to show
consumption increases
with incomes?
Did you clearly label the
different expenditure and
income levels?
E=Y
E2
E3
E1 is the original level of expenditure
E1
E2 includes the increased government
expenditure
E2 includes the increased government
expenditure and taxation
∆G
Did you clearly indicate the new
equilibriums and the multiplier effect?
Y1
Y3
Y2
Y
∆Y
Government expenditure multiplier =
Y
G
Copyright: Embedding Threshold Concepts Project
05/09/08
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: The London Olympics - how will the economy be affected?
7
(a) This requires us to use what we considered in section1B and C and the
diagram.
What is the initial effect of the increase in government expenditure?
The increase in government expenditure is an increase in injections into the
economy which increases aggregate expenditure (E1 to E2 in the diagram). This
increases output and jobs and incomes rise by the increase in injections.
What do household do with this extra income?
Most of it is probably spent on increases in consumption on domestically produced
goods. Aggregate expenditure (demand) rises. This increase in consumer
expenditure leads to additional employment and hence income and again
consumption rises and so on. This is known as the multiplier effect.
But what else do households do with the extra income?
They also have to pay more taxes, they may save more and spend more on
imported goods. This is important: withdrawals increase as incomes increase.
The size of this effect depends on the marginal propensity to withdraw (mpw). It
means that the extra amount of consumption is smaller than the increase in
incomes. This is part of the process of restoring equilibrium – injections have gone up
and so will withdrawals (an endogenous effect).
Equilibrium is achieved when income has risen sufficiently to give an increase in
withdrawals that is equal to the increase in government expenditure (the increase in
injections), which is where planned expenditure = planned income (Y = E in the
diagram). Income has increased from Y1 to Y2, which is larger than the increase in
government expenditure from E1 to E2. The ratio of these is the multiplier.
Copyright: Embedding Threshold Concepts Project
05/09/08
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: The London Olympics - how will the economy be affected?
8
(b)
How should we approach this more complicated question?
This part of the question involves two changes. In economic modelling we usually:
(i) analyse the various changes separately and then
(ii) combine the effects.
This is because the changes may have different effects and it is simpler to trace
through the individual effects separately. Only if we are sure that the two changes
have the same effect on expenditure in our model can we put them together
initially and consider the net affect.
We have already considered the increase in government expenditure, so we now
need to consider the effect of taxes and then put the two effects together.
What is the main effect of the increase in taxes on households?
They have to pay the taxes and the most important effect is that they will spend less
on consumption of domestically produced goods. This increase in taxes is a policy
induced increase in withdrawals into the economy and reduces aggregate
expenditure.
But are there any other ways in which households cut back in order to pay the
taxes?
They are also likely to cut back on savings and buying imported goods. This means
that the initial reduction in consumption on domestically produced goods caused
by the policy is by LESS than the increase in taxes.
What then is the combined effect of raising government expenditure and raising
taxes by the same extent?
The point above means that the initial effect of the increase in taxes (downwards) is
smaller the initial effect of the government expenditure (upwards) on aggregate
(total) expenditure. Thus in the diagram the effect of taxes is show as E2 to E3,
reducing but not nullifying the effect of the government expenditure change.
Therefore the combined effect will be of a small shift in aggregate expenditure from
E1 to E3.
This small effect will be magnified by the multiplier effect in the normal manner.
Income increases from Y1 to Y3.
Copyright: Embedding Threshold Concepts Project
05/09/08
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: The London Olympics - how will the economy be affected?
9
Feedback Section 2: The effect on the economy
(Basic)
(a) This requires us to use what we considered in 1B and C. We illustrate the
points on the diagram (particularly those in bold).
What is the initial effect of the increase in government expenditure?
The increase in government expenditure is an increase in injections into the
economy. This increases output and jobs and hence incomes increase.
What do household do with this extra income?
Most of it is probably spent on increases in consumption on domestically produced
goods. Aggregate expenditure (demand) rises. This increase in consumer
expenditure leads to additional employment and hence income and again
consumption rises and so on. This is known as the multiplier effect.
Circular Flow of Income
More Withdrawals
as incomes ↑
S
T
M
Gov’t Exp up
More Injections
Increase in consumption
I
X
Firms
Households
Increase in incomes
• But what else do households do with their extra income?
They have to pay more taxes, may save more and spend more on imported
goods. This is important: withdrawals increase as incomes increase.
• The size of this effect is known as the marginal propensity to withdraw (mpw). It
means that the extra amount of consumption is smaller than the increase in
incomes.
• Equilibrium is achieved when income has risen sufficiently to give an increase in
withdrawals that is equal to increase in government expenditure (the increase
in injections).
Copyright: Embedding Threshold Concepts Project
05/09/08
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: The London Olympics - how will the economy be affected?
10
(b) How should we approach this more complicated question?
This part of the question involves two changes. In economic modelling we usually:
(i) analyse the various changes separately and then
(ii) combine the effects.
This is because the changes may have different effects and it is simpler to trace
through the individual effects of one change first, then the second change and then
put the two together. Only if we are sure that the two changes have the same
effect on expenditure in our model can we put them initially together and consider
the net affect.
We have already considered the increase in government expenditure, so we now
need to consider the effect of taxes and then put the two effects together.
What is the main effect of the increase in taxes on households?
They have to pay the taxes and the most important effect is that to do that they will
spend less on consumption of domestically produced goods. This increase in taxes is
a policy induced increase in withdrawals into the economy.
But are there any other ways in which households cut back in order to pay the
taxes?
They are also likely to cut back on savings and buying imported goods. This means
that the reduction in consumption on domestically produced goods is by LESS than
the increase in taxes.
What then is the combined effect of raising government expenditure and raising
taxes by the same extent?
The point above means that the initial effect of the increase in taxes (downwards) is
smaller the initial effect of the government expenditure (upwards) on the circular
flow. Therefore the combined effect will be of a small increase in incomes in the
circular flow.
This small effect will be magnified by the multiplier effect in the normal manner. This
increase in income will lead to increased consumption which will in turn lead to
more output and employment, and hence income again rises (but by less than the
initial rise as withdrawals – saving and imports – also increase) and so on.
Copyright: Embedding Threshold Concepts Project
05/09/08
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: The London Olympics - how will the economy be affected?
11
Reflection:
After completing this activity do you understand:
Yes
Partly
No
1. The multiplier as well as the initial effects of
expenditure changes?
2. How equilibrating forces effect withdrawals?
3. The use of the diagram?
If your answer is ‘No’ or ‘Partly’ to any of the above, which of the following do you
now intend to do to improve your understanding?
1. Ask for guidance from my tutor?
2. Read a relevant section in a textbook?
3. Work though some example questions?
Copyright: Embedding Threshold Concepts Project
05/09/08
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: The London Olympics - how will the economy be affected?
12
Notes for lecturers
Objectives of the exercise and prerequisites
This exercise presents a scenario students are likely to have heard/read about in the
media. However, a crucial point for them to appreciate is that they do not have to
know details of the event, but they do have to apply economic modelling.
Learning Focus: developing an understanding of macroeconomic models and the
government expenditure and taxation multipliers. A particular concern is how
equilibrating forces are important in economic models.
Threshold Concepts that are important to this learning are economic modelling,
marginality, interaction between markets and the multiplier (cumulative causation).
We found in our ‘Embedding Threshold Concepts’ project that students had
difficulty in understanding the role of equilibrium in our models and this led to
difficulties in understanding the multiplier. In particular students did not recognise
that there was a limit to the process because they had not clearly identified the
endogenous processes that lead to equilibrium. The feedback and reflection
questions for this activity stress this aspect of understanding.
Prior Knowledge Required
In order to allow this exercise to be used with different groups of students (e.g.
business students as well as those taking an economic award), or at different
junctures in a module, the feedback is available at two levels for you to choose:
(a) for students who have only covered the circular flow of income and a
general introduction to the idea of the multiplier (labelled basic)
(b) for students who have covered the income/expenditure model (labelled
intermediate).
Sequencing and timing
1. The feedback to section 1 should be given to students before they attempt
section 2. In a tutorial situation this can be done verbally.
2. For students who have covered more macroeconomic models, we have
included a section on choosing an appropriate diagram. You may want to
amend this section, depending on what your students have covered. This is
not available in the version using the circular flow in feedback, the
assumption being that students using this version will not have met other
models.
3. The exercise will take around 45 minutes to complete.
Copyright: Embedding Threshold Concepts Project
05/09/08
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.