Monday, March 23, 2009

What Does Fiscal Stimulus Mean?

This is a guest post from Manshu, author of 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:

  1. 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.
  2. 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?

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