Policy Mix in a High-Debt Economy
Country A has potential GDP of $2,000 billion and actual GDP of $1,880 billion. Unemployment is 8.5%, and CPI inflation is 5.2%, well above the central bank's 2% target. The policy interest rate is 5.75%. Government debt is 95% of GDP, and the deficit is 4.5% of GDP. The marginal propensity to consume out of disposable income is 0.75, and the average tax rate is 20%. The central bank has a credible inflation-targeting framework but its mandate also includes supporting growth 'subject to price stability'. The finance ministry proposes a $60 billion infrastructure spending package, arguing that the multiplier will close the output gap. A rival economist warns that crowding out and import leakage will reduce the effect, and that the package will worsen inflation.
1. Calculate the output gap as a percentage of potential GDP and the simple multiplier implied by the data. Estimate the initial fiscal impulse needed to close the gap, stating assumptions.
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Output gap = (actual - potential)/potential = (1,880 - 2,000)/2,000 = -6.0%, i.e. a recessionary gap of $120bn. With MPC = 0.75 and tax rate t = 0.20, the multiplier is k = 1/[1 - MPC(1 - t)] = 1/[1 - 0.75(0.8)] = 1/0.4 = 2.5. The required initial fiscal impulse is $120bn/2.5 = $48bn. A $60bn package would, on these assumptions, raise equilibrium GDP by $150bn, overshooting potential by $30bn and adding to inflation. Assumptions: closed economy, no crowding out, fixed price level, all spending on domestic output, and no supply-side effects. In an open economy with import leakage, the multiplier would be smaller, so the required impulse would be larger; with crowding out, it would also be larger. The calculation is therefore a first approximation, not a forecast.
2. Evaluate the finance ministry's proposal in light of the inflation rate and the debt level.
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With inflation at 5.2% and the policy rate already 5.75%, a $60bn demand expansion is risky. It would raise aggregate demand further. Even though the output gap is negative, high inflation suggests supply shocks or inflation expectations, so the gap may be partly structural. Crowding out is a real risk: debt is 95% of GDP and the deficit is 4.5%, so additional borrowing may raise interest rates and crowd out private investment. Import leakage reduces the multiplier. The debt level also limits fiscal space; a permanent spending package could undermine credibility. My judgement: a smaller, targeted package of $48bn or less, focused on supply-side infrastructure that raises potential output, is preferable; it should be paired with a credible fiscal consolidation path. Monetary policy should remain tight until inflation falls, and automatic stabilizers should be allowed to work.
3. Discuss whether monetary or fiscal policy is more appropriate given the central bank's mandate and a floating exchange rate.
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Monetary policy is more appropriate for hitting the inflation target because the central bank has instrument independence and a credible framework. Fiscal policy is slower to legislate and harder to reverse, and at 95% debt it risks credibility. However, monetary tightening alone may deepen the recessionary gap, especially if the gap is cyclical. The floating exchange rate gives the central bank autonomy, but higher rates attract capital and appreciate the currency, hurting net exports and reducing aggregate demand further. A coordinated mix is better: monetary policy controls inflation, while fiscal policy targets the output gap with time-limited, supply-side spending. The central bank's secondary growth mandate means it should not ignore the gap, but 'subject to price stability' implies inflation comes first. The judgement is that fiscal policy should be used selectively, not as the main instrument, and that the finance ministry's $60bn proposal is too large.