Economic Stimulus

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What is an 'Economic Stimulus'

Economic stimulus consists of attempts by governments or government agencies to financially stimulate an economy. An economic stimulus is the use of monetary or fiscal policy changes to kickstart growth during a recession. Governments can accomplish this by using tactics such as lowering interest rates, increasing government spending and quantitative easing, to name a few.

BREAKING DOWN 'Economic Stimulus'

Over the course of a normal business cycle, governments may try to influence the pace and composition of economic growth using various tools at their disposal. Central governments, including the U.S. federal government, may utilize fiscal and monetary policy tools to stimulate growth. Similarly, state and local governments can also engage in stimulus spending by initiating projects or enacting policies that encourage private sector investment.

Economists Debate Merits of Stimulus

Like many things in economics, stimulus programs are somewhat controversial. John Maynard Keynes, a British economist from the early 20th century, is most often associated with the concept of economic stimulus, sometimes referred to as counter-cyclical measures. His general theory argued that during times of persistently high unemployment, governments ought to deficit spend in an effort to stimulate further demand, elevate growth rates, and reduce unemployment. In stimulating growth, deficit spending could, in some circumstances, pay for itself through higher tax revenues resulting from faster growth.

Potential Risks of Stimulus Spending

There are several counter-arguments to Keynes, including somewhat theoretical debates about the "Ricardian equivalence" and the concept of crowding out. The former, named for David Ricardo's work dating back to the early 1800s, suggests that consumers internalize government spending decisions in a way that counterbalances current stimulus measures. In other words, Ricardo argued that consumers would spend less today if they believed they would pay higher future taxes to cover government deficits. Although empirical evidence for the Ricardian equivalence is not clear, it remains an important consideration in policy decisions.

The crowding-out critique suggests that government deficit spending will reduce private investment in two ways. First, rising demand for labor will increase wages, which hurts business profits. Second, deficits must be funded in the short-run by debt, which will cause a marginal increase in interest rates, making it more costly for businesses to obtain financing necessary for their own investments.

Additional arguments against stimulus spending recognize that some forms of stimulus may be beneficial on a theoretical basis, but it faces practical challenges. For example, stimulus spending may occur at the wrong time due to delays in identifying and allocating funds. Second, central governments are arguably less efficient at allocating capital to its most useful purpose, leading to wasteful projects that have a low return.