This is a guest post from Manshu, author of OneMint.com who started writing articles when he was majoring in finance.
With the economy reeling under a recession, the word that you read quite frequently is stimulus. But what is it? First, let’s explore a few terminologies: recession, GDP, consumption among others.
A recession is characterized by the contraction of a country’s Gross Domestic Product (GDP). The GDP sums up the total economic activity that happens within a country and is the sum of the following things:
GDP = Consumption + Government Spending + Investments + Net Exports (Exports – Imports)
Consumption refers to the money spent by private households and businesses on the things that they consume. As you can well imagine, consumption shrinks considerably during recessionary times.
Why you may ask? The number of times you go to a restaurant reduces and so does the number to the grocery store visits. As a result, the income of the grocery store and restaurant goes down too. When that happens, they lay off their employees and those employees further reduce spending. Because of this, businesses are discouraged from expanding and going out on new ventures and the investments in the above equation goes down as well.
Economists call this the fall in Aggregate Demand.
In order to stem this fall, the government launches a spending program to boost the aggregate demand and stimulate spending and economic activity. This is known as a Fiscal Stimulus.
There are various ways in which a fiscal stimulus can be administered but there is no solution that can fit all situations.
The two main ways of providing fiscal stimulus are:
- Tax Cuts: By cutting taxes, the government allows people to keep more in their pockets and ultimately spend more. This increases Consumption in the above equation.
- Government Spending: Direct government spending in infrastructure, social welfare or other such things increases the Government Spending in the above equation and helps boost the GDP.
When there’s talk about fiscal stimulus, you will sometimes hear people talk about the multiplier effect. What this basically means is for the effect (in dollar terms) of the economy with every dollar that the government spends. Hopefully, this is more than 1 (ie, the economy grows by $1.50 for every $1 that the government spends). There are currently debates on what the multiplier truly is right now and whether it even exists.
There’s also debates on whether tax cuts or government spending programs are better for the economy and I think that this debate is largely unresolved as there is no clear indication that one is always better than the other. What do you think? Do you favor tax cuts or would you rather have the government put more programs in places that they deem of need?
{ read the comments below or add one }
Well explained. Thank you.
It’s interesting that at the moment Government’s across the world are trying to both cut taxes and increase Government spending (especially on infrastructure projects) but it just doesn’t seem to be making much of a difference. I think this just goes to show how CRITICAL public confidence is to boosting spending as well.
Hello there. When you have the 2nd option (Gov Spending) from where is the money coming from ?
Almost all of government spending is from taxes but once in a while, government programs run surpluses. Of course, a government can borrow by issuing treasuries more quickly and efficiently than any other entity so they can keep spending as long as investors are willing to accept their debt.
Very good post. One other fact worth mentioning:
The main tool used to stimulate the economy is usually through monetary policy, through the lowering of interest rates. This helps smooth out the business cycle. When things heat up too much (causing rising inflation) the fed increases rates to slow down the consumption part of this equation. In the other direction, to fuel this part of the equation, it lowers rates.
The problem right now is that the rates are almost zero and people still aren’t increasing this part of the equation. They are not interested in borrowing, in fact are decreasing their debt and increasing their savings.
You are correct that tax cuts or government spending are the next tools to feed the equation. In a situation such as ours, where incremental dollars are being saved or used to pay down debt, tax cuts are not as effective. If people save the tax dollars or pay down credit with those tax savings, GDP is not helped.
That’s why the government has stepped in to stimulate the economy. When the private sector is cutting back on employment, the government is the employer of last resort. The intention is not to “save people from bad decisions,” it’s simply to try and get the economy working in the other direction, where people become employed again and are able to fend for themselves.
MoneyNing, I wasn’t thinking of the government saving individual people from bad decisions, so much as reinforcing irresponsible behavior of state governments. I offer California, New York and Michigan as examples. Decades of reckless spending on the part of those governments have led to billion dollar deficits and borderline insolvency. Now, they get a federal bailout in the form of the Stimulus spending, but they have no incentive to change their behavior to avert disaster in the future. There’s a fine line between money for infrastructure projects and bailouts in many cases.
@Manshu: What I have seen locally is that the money keeps moving around locally. Say someone leaves a tip for my daughter, the bartender. She puts the tip money into her gas tank at the local station and some into clothes for the kids at a garage sale. The gas station owner, who also works the pumps and we’ve known forever, takes the money and buys a part for his lawnmower at the parts store. He then pays his kid to mow the lawn, so the kid also has spending money. The parts store owner goes and buys something locally, like the local paper. The garage sale lady takes the money down to the farmers’ market and buys locally produced food. The marketerr has a good day and goes out to the bar to celebrate and gives my daughter the bartender a tip again…. around and around the money goes cuz it stays at home in the local economy….. Sure this is a simplified version…. BUT… now think what happens when the bartender doesn’t buy locally – but takes the money over the hill to the “big town”, ie overseas or out of country for example…. None of the money goes around and around in our little town. No more excitement about seeing money and then feeling ok to spend it. It may be the same dollar over and over again, but seems to me it grows as it spreads around…. at least we locals are happy with the results.
Sounds like a wonderful community in which to live ! Many of us stay in our little isolated suburban houses and buy stuff on-line with money going who the heck knows where. Glad to know there is a healthy community dynamic working somewhere !!
@Joe Morgan If you look at infrastructure spending and other stuff that forms part of the stimulus that really doesn’t set a precedent of government saving people from bad decisions. Its just these bailouts and bonuses that create moral hazard.
@John: You are absolutely correct about the long term solution to the problem. In the short term, however, there needs to be some mechanism to help save the economy from entering a deflationary spiral, which is where the stimulus will come in handy.
@Marci: It would be interesting to hear from you what your experience of the multiplier effect in your area has been.
@Kai Lo: There is no doubt that the stimulus is a short term mechanism. I just hope that it does prove effective in the short run.
Thanks to everyone for weighing in.
@MoneyNing:
I hear what you’re saying on the “jump start” to the economy, but it will come at a very hefty price. I also believe it sets a dangerous precedent in many people’s minds that the Government will just swoop in and take care of things when times get tough.
I’m thinking of higher inflation down the road as well as higher taxes – both of which will stifle the economy, perhaps when it just starts to rebound. It’s like kicking the can down the road to worry about it later, but never dealing with the problem and maybe making it worse.
The debate is proving to be a good food for thoughts for financial pundits in this turmoil times. But what i believe is that, government pumping in funds will not be efficacious in solving the problem in the longer run and it will be only a stopgap arrangement. The problem should be rooted out once and for all.Giving tax cuts and other sops will also make people more sensible in their spending and will not incur any cost imminently and only lead to fiscal deficit which can be replenished later.Once pumping in funds comes to halt the whole cycle would unwind again, wheres fiscal prudence will be effective even in the longer run. Eventhough government has to bite some pills initially, it will alleviate the economic turbulence in the longer run adequately.
Joe: I don’t believe anyone is saying that the multiplier effect is sustainable. The government is hoping (as do many others) that the stimulus will be enough to jump start the economy again because a stalled economy is bad for everyone.
@MoneyNing,
One more thing regarding the multiplier effect on the economy with government spending:
If there really was a sustainable multiplier on government spending, then we wouldn’t need a public sector. Furthermore, government could just keep printing money indefinitely because the result would yield more than the cost. It fails the common sense test.
An increase in Government spending only increases the GDP in the short term. Eventually, we have to pay for this increase with either higher taxes or higher inflation or, more likely, both.
Government ‘stimulus’ is like chugging a caffeine drink loaded with sugar – you get a short term boost of energy (GDP) but the after effect leaves you in worse condition than if you hadn’t taken it. The net effect will be either nil or less than the cost.
Sadly, the only time horizon politicians know is the next election cycle.
I’ve seen the multiplier effect working here in our small rural town, so I believe in it on a small local scale.
I would like to see more stimulus programs that put people to work, like on our state’s terrible roads, etc. But I am ALWAYS for a personal tax cut.
When there is a tax cut, the Government will find other ways to get more fundings which ultimately come out of your pockets. This stimulus will only help for the short run.
Thanks for letting OneMint appear here MoneyNing. I am not sure about the multiplier effect as that has a lot of ifs and buts and there certainly is no consensus about it. I hope it takes place but not sure it will.
I don’t know the answer to this but I definitely hope that government spending will have an multiplier effect on the economy. Otherwise, I feel that all my tax payer dollars are doing is transferring from my pocket to someone else’s because of government inefficiencies.