Fiscal Choice in a Eurozone Economy Near Full Employment
A small eurozone economy has inflation at 4.6%, unemployment at 3.4%, GDP growth at 1.2%, and public debt at 58% of GDP. GDP is €14 billion. The government is debating a €300 million package. Option A is a universal energy subsidy costing €300 million, estimated to reduce headline inflation by 0.8 percentage points but raise import demand. Option B is €300 million on vocational training and childcare, with an estimated fiscal multiplier of 0.7 after two years and a supply-side effect of raising potential output by 0.3%. The ECB has raised rates to 4.0%; the country's banking sector is exposed to variable-rate mortgages. The finance ministry fears debt rising above 60% and a wage-price spiral; unions demand support for low-income households. The budget must be approved in eight weeks. The economy is close to full employment.
1. Classify the inflation as primarily demand-pull or cost-push, and assess whether Option A is likely to reduce underlying inflation. Use the data.
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Unemployment at 3.4% is low, suggesting the economy is near full employment; growth is only 1.2%, so inflation is unlikely to be purely demand-pull. The 4.6% rate probably has a large cost-push or energy component. A universal energy subsidy lowers headline inflation by 0.8 percentage points, but headline is not underlying inflation. By supporting household demand in a tight labour market, it risks a wage-price spiral and raises import demand, worsening the external balance. It is costly at €300 million and poorly targeted. Option A may reduce measured inflation temporarily but is weak on underlying inflation. A targeted transfer to low-income households would protect real incomes with less demand leakage.
2. Using the multiplier, calculate the two-year impact of Option B on GDP, and evaluate whether it is preferable to Option A given the debt rule and ECB policy.
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GDP is €14 billion; €300 million is 2.14% of GDP. Option B's multiplier of 0.7 gives €210 million extra GDP after two years, or 1.5% of GDP. The supply-side effect raises potential output by 0.3%, about €42 million, so some of the demand effect is absorbed by higher capacity rather than inflation. Debt at 58% is €8.12 billion; adding €300 million raises it to about 60.1% of GDP unless offset, breaching the 60% threshold. Option A has no supply-side payoff and is universal, so its import leakage and inflation risk are higher. Option B is preferable on efficiency and inflation risk, but at near full employment a €300 million unfunded demand injection is still poorly timed with ECB tightening. Recommend a smaller, targeted package, for example €150 million on training and childcare funded by reallocating low-priority spending or revenue, keeping debt below 60%, plus targeted energy support. This addresses the unions' equity concern without a universal subsidy.