Fiscal Stimulus in a Near-Full-Employment Economy
A government announces a $30 billion infrastructure package over three years, funded by borrowing. The economy is at 4.2 per cent unemployment with an estimated NAIRU of 4.5 per cent, so it is near full employment. The marginal propensity to consume is 0.7, and the marginal propensity to import is 0.15. The output gap is estimated at −0.5 per cent of GDP. Public debt is 55 per cent of GDP and the ten-year bond yield has risen 60 basis points since the announcement. The government argues the package is about productive capacity, not demand management.
1. Calculate the simple multiplier and use it to assess the demand-side effect of the package relative to the output gap.
Read the worked answer
Multiplier = 1 / (1 − MPC + MPM) = 1 / (1 − 0.7 + 0.15) = 1 / 0.45 ≈ 2.22.
Demand effect: $30 billion over three years is roughly $10 billion per year. At a multiplier of 2.22, the annual demand impact is about $22 billion. The output gap is −0.5 per cent of GDP; if GDP is, say, $2 trillion, the gap is about $10 billion. So the annual stimulus is roughly twice the size of the gap.
Assessment: the demand injection is large relative to the gap, which means the package is not primarily filling spare capacity. With unemployment at 4.2 per cent, below the 4.5 per cent NAIRU, the economy is already tight, so much of the demand effect will show up in prices and wages rather than output. The multiplier estimate is also a simplification: it ignores crowding out, supply constraints, and the construction-sector capacity limits that typically bind on infrastructure.
Judgement: the demand-side case is weak as countercyclical policy; the package only makes sense on the supply-side argument the government is making.
2. Evaluate the government's claim that the package is about productive capacity, using the bond yield and debt data.
Read the worked answer
Supply-side case: infrastructure can raise productive capacity by reducing transport and logistics costs, which shifts aggregate supply right over time. If that happens, the inflation risk of the demand injection is partly offset. This is the strongest version of the government's argument, and it depends on project selection and completion, not just announcement.
Bond yield signal: a 60 basis point rise since announcement suggests markets price higher borrowing, higher expected inflation, or crowding out of private investment. At 55 per cent of GDP, debt is moderate, but the yield move indicates the fiscal space is not unlimited. Higher yields raise the government's own interest costs and can crowd out private capital that would also add capacity.
Judgement: the claim is plausible but unproven. The demand effect arrives before the supply effect, so the near-term result is likely inflationary pressure in a tight economy. The claim would be credible if the package were backloaded toward projects with high measured returns and paired with offsetting savings; as announced, the timing and the yield response undercut it.