Fiscal Stimulus under a Linked Exchange Rate
A small open economy with a linked exchange rate is operating 2% below potential output. The government proposes HK$12 billion of new spending on drainage works. Of each extra dollar of disposable income, households spend 80 cents; of that spending, 30 cents is on imports. The marginal tax rate is 20%. The economy's aggregate supply curve is upward-sloping but becomes steep near potential output. The government can finance the spending by issuing bonds to domestic banks, which currently hold excess reserves; alternatively, it can raise the profits tax. The central bank will not change interest rates because of the peg. Private investment is sensitive to interest rates but not to the spending itself. The finance ministry estimates the spending will be spread over two years and that 40% of the materials will be imported.
1. Calculate the open-economy multiplier and the total effect of the HK$12 billion spending on GDP. State your assumptions.
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Let the marginal propensity to consume out of disposable income be 0.8, the tax rate be 0.2, and the import share of consumption be 0.3. Disposable income rises by 0.8 of any extra national income, consumption rises by 0.8 times 0.8, or 0.64, and imports rise by 0.3 times 0.64, or 0.192. Domestic consumption therefore rises by 0.64 minus 0.192, or 0.448 per extra dollar of income. The multiplier is 1 divided by 1 minus 0.448, which is 1 divided by 0.552, or about 1.81.
Because 40% of the materials are imported, only 60% of the HK$12 billion, or HK$7.2 billion, is a direct domestic injection. The total GDP effect is approximately HK$7.2 billion times 1.81, or HK$13.0 billion over the period. If the spending is spread evenly over two years, the annual effect is about HK$6.5 billion per year. This assumes fixed prices, no capacity constraints, no crowding out, and that the import shares remain constant.
2. Assess whether bond finance or tax finance is more appropriate given the output gap and the peg.
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The economy is 2% below potential output, so there is room for expansion without immediate inflation. Bond finance from domestic banks with excess reserves is less likely to crowd out private investment, because the banks can buy the bonds without reducing loans sharply. Tax finance would reduce disposable income and partly offset the stimulus; a higher profits tax could also reduce investment. Because the peg prevents an independent monetary contraction, fiscal policy is not offset by the central bank, so the multiplier can operate.
However, bond finance increases public debt and may raise interest rates if banks become less willing to hold government paper. Near potential output, the aggregate supply curve becomes steep, so further stimulus could cause inflation rather than output growth. Judgement: bond finance is preferable in the short run while the output gap is negative, provided the spending is temporary and targeted. If debt sustainability is a concern, tax finance may be safer, but it weakens the stimulus.
3. Explain how the 40% import content and the linked exchange rate affect the multiplier and the current account.
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The 40% import content is a leakage from the circular flow. Only 60% of the government spending becomes demand for domestic output, so the first-round injection is smaller than HK$12 billion. The import share of consumption further reduces the multiplier to about 1.81, because each round of domestic spending leaks into imports. A higher multiplier would require a larger domestic content and a lower import propensity.
The linked exchange rate fixes the exchange rate, so the economy cannot depreciate to offset the leakage by making exports cheaper. Higher government spending raises imports of materials and consumer goods, which worsens the current account or reduces a surplus. With the peg, the central bank cannot cut interest rates to boost domestic demand; any defence of the peg may require higher interest rates if capital flows out. The fiscal stimulus therefore has a smaller domestic effect and a larger import effect than it would in a closed economy.