Worked example 1
An economy is in recession with unemployment at 9% (NAIRU 5%), inflation at 0.5%, interest rates at 0.25%, and a budget deficit of 6% of GDP.
Evaluate the effectiveness of (i) further expansionary fiscal policy and (ii) quantitative easing in restoring full employment while maintaining price stability. [15 marks]
Show solution outline
Context: Deep recession (U 9% >> NAIRU 5%), deflation risk (0.5% inflation), rates at zero lower bound — conventional monetary policy exhausted.
(i) Expansionary fiscal policy:
Strengths:
- Direct AD boost via ↑G or ↓T — multiplier effect raises Y and reduces cyclical unemployment.
- Automatic stabilisers already operating; discretionary spending (infrastructure) adds jobs quickly.
- With inflation near zero, demand-pull inflation risk is low — spare capacity absorbs stimulus.
Weaknesses:
- Deficit already 6% of GDP — further borrowing raises debt sustainability concerns; may raise long-term interest rates (crowding out).
- Implementation lags for new projects.
- Political constraints on increasing deficit.
(ii) Quantitative easing:
Strengths:
- Only remaining monetary tool at 0.25% floor — asset purchases lower long-term rates.
- Supports investment and asset prices → wealth effect may boost C.
- No direct increase in public debt from QE itself (though fiscal and monetary may coordinate).
Weaknesses:
- Uncertain transmission — banks may not lend if confidence low.
- Distributional effects — benefits asset holders more than unemployed.
- Does not directly create jobs like fiscal spending on infrastructure.
Judgement / policy mix:
- Fiscal policy more effective for reducing unemployment in this scenario — direct job creation, multiplier, low inflation allows stimulus.
- QE as complement — keeps long rates low, supports investment.
- Supply-side (retraining) needed for any structural component of 9% unemployment.
- Price stability likely maintained given large output gap — both policies appropriate.