An economic stimulus package is a combination of economic measures utilized by a government to stimulate a struggling economy. The stimulus package can be used as a preventive or reversing measure to stop or prevent a recession by lowering interest rates, increasing government spending, and quantitative easing, etc. aimed at increasing employment and consumer spending.
Economic stimulus follows the ideologies presented by British economists John M. Keynes (Keynesian economics) and Richard Kahn’s theories on the fiscal multiplier concept. In more colloquial terms, economic stimulus is also known as “pump-priming” or “priming the pump.”
Understanding Economic Stimulus Packages
When a government anticipates an economic recession, it can enact a coordinated effort to lessen the impact of the recession or stave it off completely. The government enacts a series of economic measures in the form of an economic stimulus package. The measures are carried out as a means to take advantage of the impactful multiplier effects and to ultimately increase the consumption in the private sector and encourage investment spending.
The economic stimulus package will involve the use of either monetary policy, fiscal policy, or both.
1. Monetary policy
Monetary policy refers to measures taken by the central bank of a country to control the supply of money in an economy. It consists of managing the money supply and controlling interest rates. It can be done in a few ways, such as:
Altering the capital reserve requirements of banks
Selling or buying government bonds on the open market
The central bank is an independent institution with the mandate to ensure inflation, employment, and GDP growth meets certain targets. The central bank achieves its goals through the monetary policy tools outlined above.
The objective of monetary policy is to control inflation, consumption, and economic growth. An expansionary monetary policy aims to increase the macroeconomic factors, whereas a contractionary monetary policy aims to decrease them.
2. Fiscal policy
Fiscal policy refers to government spending and taxation policies used to influence the overall economic conditions of a country. In contrast to monetary policy, fiscal policy is not associated with the central bank of a country. Instead, it is a policy enacted by the government itself. The government uses fiscal policy in ways, such as:
Increasing or decreasing government spending on projects
Increasing or decreasing tax rates
A government may pull the levers in certain economic situations so that the economy does not go into recession or overheat. In the face of a recession, a government can act through expansionary fiscal policy, where it increases government spending and decreases taxes to stimulate the economy.
In the case of an overheating economy, a government can act through contractionary fiscal policy, where it decreases government spending and increases taxes to cool off an economy.
Economic Impact of Economic Stimulus Packages
An economy is in a recession when economic activities decline over two fiscal quarters. It is usually visible in a decrease in the gross domestic product (GDP). In order to combat a recession, a government and central bank will coordinate their efforts to drive gross domestic product upwards. The components of GDP are as follows:
An economic stimulus package aims to increase a country’s GDP by influencing the individual components upwards through its actions.
1. Altering the capital reserve requirements of banks
By altering the capital reserve requirements of banks, the central bank allows banks to either increase their lending capacity or force them to decrease their lending capacity. In a recession, the central bank will lower the reserve requirements, and, in turn, banks will be able to lend out more money. More lending can stimulate the economy by increasing consumption and investment.
2. Selling or buying government bonds on the open market
By selling or buying government bonds on the open market, the central bank either increases or decreases the amount of money in the hands of consumers. In a recession, the central bank will buy government bonds on the open market, thereby leading to more money in the hands of consumers that can be used for consumption or investment.
3. Modifying the central bank interest rate
By modifying the central bank interest rate, the central bank is aiming to influence the demand for lending and saving. In a recession, a low interest rate will entice people and businesses to take out more loans and increase their spending. Also, low interest rates decrease the incentive to save money and will increase consumption.
4. Increasing or decreasing government spending on projects
By increasing or decreasing government spending on projects, the government is able to increase employment and economic growth. In a recession, a government can increase spending on various projects to stimulate the economy.
An example is building public transit infrastructure. It will increase employment for workers on the project, and spending on materials and equipment for the project. It leads to an increase in overall consumption.
5. Increasing or decreasing tax rates
By increasing or decreasing tax rates, the government can influence both consumption and savings practices of consumers and businesses. In a recession, lower tax rates will give people and businesses more disposable income that they can use for consumption or investment.
Higher consumption leads to increased demand, so businesses will hire more workers. The increase in demand for labor will lead to wage increases, which, in turn, increases consumption in a virtuous cycle.
Risks of Economic Stimulus Packages
Economic stimulus packages are direct government intervention to keep people employed and consuming. In order to enact such measures, the government will need to take on a significant debt burden. High government debt levels lead to an increase in bankruptcy risk for a country’s government.
In theory, a government should pay back the debt in years of economic growth by increasing tax rates and decreasing spending. However, in practice, it is rarely the case, and debt levels continue to increase in perpetuity. The probability of a large, stable economy like the U.S going into bankruptcy is low, but for smaller, unstable countries, it can be a serious issue.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: