Policy Mix When GDP Is Above Potential
An economy has real GDP 2.0% above its estimated potential, unemployment at 3.9%, and CPI inflation at 5.4% (core inflation 4.8%). The central bank has a 2% inflation target and a dual mandate. The policy interest rate is 3.25%. The government deficit is 4.0% of GDP, and public debt is 85% of GDP. The government proposes $60 billion of new infrastructure spending, about 1.5% of GDP, financed by borrowing. Economists estimate the fiscal multiplier at 1.1 and the marginal propensity to import at 0.2. Infrastructure projects would take about 18 months to begin. The central bank is considering raising the policy rate by 75 basis points. Inflation expectations are currently anchored at 2.5% but have risen from 2.1% over the past year.
1. Assess the current macroeconomic stance using the output gap, unemployment, and inflation data. What monetary policy response is indicated, and why?
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The economy is operating above potential: a +2.0% output gap, 3.9% unemployment, and 5.4% inflation (4.8% core) all point to excess demand. The real policy rate is approximately 3.25% − 5.4% = −2.15%, which is highly accommodative. A simple Taylor-type benchmark with a 2% target and a 2% neutral real rate would call for a nominal policy rate well above 5.4%, not 3.25%. Raising the policy rate by 75 basis points to 4.0% would still leave a negative real rate. The central bank should tighten more decisively or signal further hikes to prevent inflation expectations, already 2.5% and rising, from becoming unanchored. The dual mandate does not justify ignoring inflation when unemployment is below estimates of the natural rate.
2. Analyze the proposed infrastructure spending. Use the multiplier and import propensity to estimate the short-run effect on GDP and the output gap, and discuss crowding out and inflation risk.
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The $60 billion package is about 1.5% of GDP. With a multiplier of 1.1, the short-run demand effect is roughly 1.5% × 1.1 = 1.65% of GDP. That would raise the output gap from +2.0% to about +3.65% before any offset. The marginal propensity to import of 0.2 is a leakage: part of the demand spills into imports, so the domestic effect is smaller than the simple multiplier suggests. Crowding out can occur through higher interest rates and higher prices, especially if the central bank tightens in response. The inflation risk is substantial because the package adds demand to an already overheated economy. A smaller, phased package or offsetting tax increases would reduce the net demand impulse while preserving some supply-side benefits.
3. Recommend a policy mix. Should the government proceed with the spending as proposed, modify it, or cancel it? Explain the tradeoffs and note one lag or credibility risk.
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The government should not proceed with the full $60 billion as proposed. It should either delay and phase the spending until the output gap closes, or finance it with offsetting revenue measures so the net demand impulse is near zero. The central bank should tighten, but fiscal and monetary policy should not pull strongly in opposite directions. The tradeoff is that infrastructure has supply-side benefits that could raise potential output, but those benefits arrive with a lag of 18 months or more, while inflation pressure is immediate. Monetary policy also works with a lag of several quarters. A credibility risk is that delaying fiscal consolidation while inflation is above target may raise inflation expectations and force a larger future tightening.