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Tax Policy Center
   Entry 9 of 13  

Economic Stimulus: When is fiscal stimulus appropriate?

Economists’ concerns about discretionary fiscal stimulus are centered on political and administrative limitations, in particular the long lags in enacting and implementing stimulus programs and the potential for politically motivated measures that are ineffective or even counterproductive at increasing short-run economic activity. However, fiscal policy has strengths as well as weaknesses.

  • Fiscal stimulus, once implemented, can affect the economy more quickly than monetary stimulus implemented at the same time-an especially important consideration if economic conditions are deteriorating rapidly. The Federal Reserve’s large-scale econometric model suggests that a 1-percentage-point drop in the federal funds rate enacted this quarter adds nothing to the level of GDP in the current quarter, 0.1 percent in the next quarter, 0.2 percent in the third quarter, and 0.4 percent in the fourth quarter. In contrast, a fiscal stimulus that distributes funds even by mid-year could have a much larger effect in the second half of the year. For example, the model finds that a temporary $70 billion tax cut, if distributed in the third quarter to households that are likely to spend much of their extra income, would boost the level of GDP by 0.5 percent during the third quarter and 0.6 percent in the fourth quarter.
  • Fiscal stimulus combined with monetary stimulus can reduce uncertainty about the total amount of thrust provided to the economy. All of the main types of stimulus-tax cuts, increases in government spending, and reductions in interest rates by the Federal Reserve-have very uncertain effects. But any surprises in the effects of these different instruments will not be perfectly correlated and will therefore cancel out to at least some extent, thus reducing the overall uncertainty.
  • Fiscal stimulus could become essential in a situation where the Federal Reserve has already lowered the federal funds rate close to zero. Although adjusting the funds rate is not its only means of stimulating the economy, the Federal Reserve has scant experience with alternatives, so their effectiveness is even more uncertain. That said, the federal funds rate today is still well above zero, so this concern has little bearing currently.
  • Fiscal stimulus would also become critical if monetary policy proves ineffective-if reducing the federal funds rate fails to lower other interest rates, or if wary lenders refuse to lend money, or if cautious consumers and businesses refuse to borrow. Consumer and business spending would then fail to rise in response to the monetary stimulus. None of those scenarios appears to apply now, however. Monetary expansions still appear to cause a wide range of interest rates to fall, and despite the credit crisis, banks appear able to lend money. Nor is there any evidence that households and businesses are unwilling to borrow more or that more borrowing would not spur more spending.
  • Fiscal stimulus is appropriate if policymakers want to achieve full employment with higher rather than lower interest rates. Monetary policy increases output by lowering interest rates; fiscal policy increases output while increasing the budget deficit, thus resulting in higher interest rates. Policymakers may fear that lower interest rates could fuel another asset price bubble or lead investors to flee U.S. assets, causing the dollar to weaken. Although those concerns have merit, other factors may militate against them. First, some depreciation of the dollar may be necessary to correct current trade and capital imbalances. Second, lower interest rates might also help deal with the ongoing problems in housing and mortgage markets-and in financial markets more generally-by supporting housing demand, easing mortgage refinancing, and boosting asset values. Finally, lower interest rates help to spur investment and thus long-term economic growth.
   Entry 6 of 10