Contextual Information
The Republic of Finistan, a medium-sized economy, is heavily reliant on its export sector, particularly the export of rare minerals used in high-tech manufacturing. A major trading partner, which accounts for 60% of Finistan’s mineral exports, underwent a severe economic downturn, leading to a sharp decline in demand for these minerals. This has had a cascading effect on Finistan’s economy, causing a prolonged recession. The recession has led to a significant increase in unemployment, especially in regions where mining is the primary industry. There’s also been a decrease in consumer and business confidence, and a deflationary spiral. The government is running a budget deficit, and public debt is at 80% of GDP. The central bank’s main interest rate is already at 0.5%, leaving little room for conventional monetary policy (changing the interest rate). In response, the government is considering a large-scale infrastructure project to build a state-of-the-art transportation network aimed at reducing transportation costs and making the mineral export sector more competitive. The cost of the project to the government will be approximately $150 billion.
Table of Data:
Questions for students:
Q1. Using an AS/AD diagram, explain how expansionary fiscal policy could close the deflationary gap in the Finistan Economy.
Q2. Using an AS/AD diagram, explain why a reduction in the interest rate is unlikely to close the deflationary gap.
Q3. Using a money supply diagram, explain why there is “little room for conventional monetary policy” to combat this recession.
Q4. The deflationary output gap in the Finistan economy is $190 billion. The Marginal propensity to tax is 0.25, the marginal propensity to save is 0.3, and the marginal propensity to import is 0.05. Calculate the size of the multiplier and then comment on whether the $150 billion infrastructure project will be enough to close the deflationary output gap.
Q5. Using information from the text/data and your knowledge of economics, evaluate the effectiveness of Finistan pursuing the infrastructure project to combat the recession.