Fiscal stimulus is used for the following purposes:
- To come out of recession
- To increase the GDP
- To increase consumption
What are they?
- A recession is characterised by the contraction of a country's Gross Domestic Product (GDP)
- GDP = Consumption + Government Spending + Investment + Net exports ( Exports - Imports)
- Consumption refers to the money spent by private households and business on the things that they consume. As you can well imagine, consumption shrinks considerably during recessionary times.
Why do GDP decrease during recession?
- 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, business are discouraged from expanding and going out on new ventures and the investments in the above equation goes down as well
Because of all the mentioned above there is a fall in aggregate demand.
Fiscal Stimulus - Pros
- Tax cuts - By cutting taxes, the government allows people to keep more in their pockets and ultimately spend more. This increases Consumption and GDP equation
- Government Spending - Direct government spending in infrastructure, social welfare or other such things increases the Government spending in the GDP equation and helps boost the GDP
- Multiplier effect - The economy grows by Rs. 1.50 for every Rs. 1 that the government spends
Because of all the mentioned above the Output increases and the Unemployment goes down.
Fiscal stimulus - Cons
- Tax Cuts - When there is a tax cut, the Government will find other ways to get more funding which ultimately come out of our pockets. This stimulus will only help for the short run
- Government spending - 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
- Politics - It is more of politics than economics. Sadly, the only time horizon politicians know is the next election cycle
There are three fallacies in the fiscal stimulus system:
- Where will the money come from? - First if the money is not to be printed it has to come from us, that is a money that we do not spend, or do not lend to a company to spend on new investment. Jobs created by fiscal stimulus are offset by jobs from the decline in private lending. We can build roads instead of factories, but fiscal stimulus can't help us to build more of both. This forms "Crowding effect"
- Higher taxes in future - If we know our taxes will go up in the future, the right thing to do with a stimulus check is to buy government bonds so we can pay those higher taxes. Now the net effect of fiscal stimulus is exactly zero, except to raise future tax distortions. The classic arguments for fiscal stimulus presume that the government can systematically fool people
- Investment is "spending" every bit as much as is "consumption" - The past stimulus program is evaluated by whether people who got stimulus money spent it on consumption goods rather than save it. But the economy overall does not care if you buy a car, or if you lend money to a company that buys a forklift
The graph below shows the net result of a one shot increase in government expenditure or decrease in tax
We see that the one shot increase in governmet expenditure leads to only a temporary increase in the inflation rate, not to an inflation in which the price level is continually rising.
Thus the fiscal stimulus would help to give a boost to the economy only in a short run. But in a long run the economy bounces back. So I would like to conclude that the cons of fiscal stimulus weighs more than the pros.
So a fiscal stimulus should never be implemented as a government policy.
