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Coursera University of Melbourne Macro Economics Course Peer Assessment Assignment

Lim Han Yang

Last week, Japan's government downgraded its views on consumer sentiment and machinery orders, while the Bank of Japan effectively cut its assessments on exports. The Wall Street Journal, August 13th, 2012. Answer either (a.1) or (a.2) and part (b). (a.1) Using the basic Keynesian model, provide a detailed analysis of the likely impact of the changes described above for Japans real GDP and rate of unemployment. (20 marks) OR (a.2) Using the Aggregate demand-inflation adjustment framework, provide a detailed, theoretical analysis of the short and long run impacts of the changes described above for Japans real GDP, rate of unemployment and inflation rate. (20 marks) AND (b) Suppose you are an economic advisor to Japans government. Would you recommend the government responds to what you have outlined above with a change in fiscal policy? Explain. (In your answer you should (i) consider what might be achieved with a fiscal policy response and (ii) the extent to which any impact on the stock of public debt might be a consideration). (20 marks)

Note: You need to demonstrate a detailed knowledge of the construction and use of the 45-degree diagram or the AD-IA model and any other economic analysis you use. You must make it clear that you have a complete understanding of the macroeconomic principles that underlie the model and concepts. Explain what assumptions you are making. Above all, explain the economics of what you are describing. It will be very difficult to obtain a passing mark for this assignment if you do not provide a complete explanation of exactly how and why the economy responds in the way that you are describing.

(a.1) The Keynesian 45 degree model, or, in other words, the Keynesian cross diagram, is a model that demonstrates the relationship between the aggregate demand and the aggregate supply in an economy from a macroeconomic perspective. In the Keynesian cross diagram, an aggregate demand (AD) curve is the rising line which increases with total national output since consumers will have a larger demand with a rise in disposable income,. This increase the result of the positive link between consumption and consumers' disposable income in the consumption function. Aggregate demand may also rise because of a rise in investment (which is due to the accelerator effect), while this rise is diminished if taxes and imports rise with income. Equilibrium in this diagram occurs where AD, equals the total amount of national output (Y) which is exchangeable with total national income or production. Here, total demand equals total supply. In this diagram shown below, the equilibrium level of output and demand is determined where this desired spending curve intersects a line that represents the equality of total income and output (AD=Y). The intersection gives the equilibrium output, Y.

Figure 1: Keynesian Cross Diagram

In the given question, Japans economy has fallen on hard times. Its government has downgraded its views on consumer sentiment and machinery orders, while the Bank of Japan effectively cut its assessments on exports.

In economic terms, this means that the consumption, investment and export functions which make up aggregate demand is about to fall. Aggregate demand is made up of consumption, investment, government spending, export and import functions. While a decrease in consumer sentiment does actually mean that consumption has fallen, for the sake of this essay I shall assume so. I am also assuming that an expected decline in machinery orders is analogous to a fall in investment, counting machinery orders as investments into capital goods. A cut in assessments on exports would mean that Japans exports are falling. Apart from question-specific assumptions, there are also several assumptions made in the use of the Keynesian cross diagram. First, the AD curve is rising. This assumption comes about because an increase in national output should lead to an increase in disposable income and, thus, an increase in consumption, which makes up a portion of aggregate demand. Secondly, the AD curve is assumed to have a positive, vertical intercept. The AD curve must have a positive, vertical intercept to cross the AD=Y curve. If the curves do not intersect, there is no equilibrium and thus, no equilibrium output can be determined. The AD curve will have a positive, vertical intercept as long as there is some aggregated demand even if there is no national output. The slope of the AD curve will be steeper given a high multiplier value. But now that the consumption, investment and export functions have fallen in Japans economy, we can now draw the Keynesian cross diagram as follows.

Figure 2: Japan's Keynesian Cross Diagram After Changes

As can be seen, Japans aggregate demand has visibly fallen, though the extent of the fall and its multiplier effects cannot be ascertained based on the current information I have. The level of national income, represented by the symbol Y has visibly been reduced too from Y to Y2 as a result of the fall in aggregate demand. As level national income is a measure of Japans gross domestic product (GDP) by the method of measuring national income, it is extremely likely, as according to the Keynesian cross diagram, that Japans real GDP is forecast to fall. The conclusion is based on the assumption that Japans GDP in the base year and all the previous years before that are on a relatively lower level than the projected GDP of the current year. If the base year of this real GDP measured was back in the 1990s when Japans Lost Decade began, for all we know, despite this recent fall in GDP, Japans real GDP might still be on the rise this year. As for the rate of unemployment, I assume were talking about cyclical unemployment here because there is not enough information given in the question to address other forms of unemployment such as structural, frictional and hidden unemployment. As seen in figure 2, with the fall in aggregate demand, there will be a rise in the rate of cyclical unemployment as there is not enough aggregate demand in the economy to provide jobs to everyone who wants to work. Aggregate demand for goods and services has fallen, resulting in less production and consequently fewer workers needed. Assuming wages are sticky downwards and do not fall to meet the equilibrium level, mass unemployment will result.

(b.) If I were an economic advisor to Japans government that is currently facing such a situation, I would certain advise some changes to its current fiscal policy stance. Firstly, as seen in figure 2, Japans fall in aggregate demand is likely to put it in a recession. The effects of such a change are numerous, harmful to the economy and not the focus of this question and as such will not be further elaborated upon. To stem the bleeding the economy is about to undertake, Japans government is advised to adopt expansionary fiscal policy. This is done via the twin methods of taxation as well as government expenditure. First off, taxation is a drag on a nations economic activity, forcing people to consume less goods and services partly as a result of the tax they may have to pay as well as keeping certain goods and services out of the reach of those who are unable to afford the tax. Now that the economy is in a recession, there is no reason such taxes should continue to be in place, especially since they are only employed to cool an overheating economy. I would recommend that the government, as part of its fiscal policy, cut its income tax rates as well as goods and services tax (GST) or value-added tax (VAT) on domestically produced goods as well as daily necessities. This is done so that consumer spending is stimulated, leading to a rise in both aggregate demand and investment as demand for more goods starts production up again. Narrowing my focus further, I would suggest, if politically possible, that the government cut the tax rate for the poor more than they do for the rich. In any society, the poor outnumber the rich many times and collectively, the poor will require more goods and service for consumption than the wealthy. Cutting taxes for the poor will thus lead to a higher stimulation of the consumption function than it will for only the rich. GST is a regressive tax as it takes up a larger percentage of a poor persons income as compared to the rich who can well afford the tax. A reduction or temporary complete removal of this tax will enable the poor to consume more and bring up his or her standard of living at the same level of income before taxes. Lastly, I recommend removing VAT on domestically produced goods so that Japans population will be encouraged to purchase locally to support the domestically economy. This helps to stimulate production which in turn increases aggregate demand to reverse the recession. VAT should be maintained or even increased on imports as it is high levels of imports that reduce the economys aggregate demand acco rding to the Keynesian cross diagram. The increase in tax revenue from this action may help fund

the government spending I am about to propose or offset the loss in revenue from cutting taxes in other areas. I do realize that this is a form of protectionism and will have a negative effect on both Japan and the worlds trade and balance of payments in the long run, which is why I recommend such a maneuver to be a temporary one, at least, until Japans economy begins to recover. Moving on to the use of government spending in fiscal policy to reverse Japans recession, as government spending is a component inside an economys aggregate demand, raising the level of government spending is the most direct way of increasing aggregate demand, national income and consequently, Japans real GDP. But what exactly should the government increase spending on that will best stimulate the economy? Public works projects that will involve hiring numerous domestic workers, especially those that have been retrenched as a result of the recession would be a good place to start. Other suggestions include subsidizing Japans key industries that possess a comparative advantage compared to other countries in the world so that its exports become more price competitive as a result of lower costs borne by the subsidies. In my view, this would be the most direct and effective method of reversing the forecasted fall in exports. This will also stimulate investment and make expanding production capacity attractive to Japans key industries, helping to bring up the expected fall in machinery orders. As an aside, such government spending will also lead to much needed inflation to make Japans exports more competitive. All in all, if Japan possesses the political will both on the domestic and world stage to adopt my suggested expansionary fiscal policy stance, the impending recession will hopefully not be as damaging as exemplified by figure 3 below.

Figure 3: Japan's Economy After Fiscal Policy Changes

One thing that is for certain is that its aggregate demand curve will rise from the previous fall to the light blue line. But whether it rises marginally (green line), adequately (dark blue line) or overheat the economy resulting in inflation (red line) is uncertain. The key economic indicators must be monitored continually to ensure no over adjustment is made that will further destabilize Japans economy. Finally, on the topic of public debt accrued from such changes in fiscal policy, it is uncertain as to whether Japans government will come out of this with a surplus or a deficit in the short term. Tax revenues will fall in many areas and rise in some others, but whether this rise is enough to offset the fall will require further analysis beyond the scope of this question. Whether the government spending that I have proposed will require the government to dip into its surplus in the previous years or even acquire a deficit is also hard to say. However the spending now is likely to be recouped in the long run when Japan s economy recovers or even overheats and the tax revenues, new cooling measures adopted or even money earned from increased exports help bring the Japans deficit back into a surplus.