What characteristics make fiscal stimulus most effective?
When the economy is operating below its potential, fiscal stimulus can raise output and incomes in the short run. To have the greatest impact with the least long-run cost, the stimulus should be timely, temporary, and targeted.
Fiscal stimulus can raise output and incomes in the short run when the economy is operating below its potential. To have the greatest impact with the least long-run cost, the stimulus should be timely, temporary, and targeted. Timely, so that its effects are felt while economic activity is still below potential; when the economy has recovered, stimulus becomes counterproductive. Temporary, to avoid raising inflation and to minimize the adverse long-term effects of a larger budget deficit. And well targeted, to provide resources to people who most need them and will spend them: for fiscal stimulus to work, it is essential that the funds be spent, not saved.
Making fiscal stimulus timely is especially challenging because it involves not just enacting tax cuts or spending but also implementing them. Poorly timed fiscal policy can destabilize the economy, intensifying rather than damping the business cycle. If fiscal stimulus is enacted too slowly, it might fail to prevent a drop in output and incomes, or arrive after recovery has begun, leading to overexpansion and higher inflation.
Fiscal stimulus should be temporary because, in the long run, the Federal Reserve generally keeps the economy operating close to full employment and full capacity through monetary policy. This means that, most of the time, fiscal stimulus would not increase output, but instead simply crowd out other economic activity or induce the Federal Reserve to tighten monetary policy in order to keep inflation down.
Over the long run, permanent tax cuts or increases in government spending not matched by changes on the other side of the ledger reduce national saving, resulting in lower investment or more foreign borrowing. This, in turn, diminishes economic growth and future national income. Also, larger expected budget deficits tend to push up long-run interest rates, which restrain investment and weaken net exports by pushing up the value of the dollar—effects that will undo part or all of the direct stimulative effects of lower taxes or higher government spending. Therefore, a temporary stimulus is likely to be more effective than a permanent policy change, and at a much lower long-run cost.
Fiscal stimulus should be well targeted in two ways. First, it should go to households or businesses most likely to raise spending in response to the stimulus and thus increase gross domestic product in the short run. Second, it should provide the greatest benefit to people most adversely affected by the slowdown. These two aspects of targeting are complementary. Higher-income households can generally smooth their consumption over the business cycle by drawing down their savings or borrowing. Therefore directing resources to them will likely have little effect on consumer spending. In contrast, lower-income families are more likely to cut back their consumption in hard times. These families are likely to spend any additional money they receive from tax cuts or transfer payments, which helps protect them from the downturn while also boosting the economy.
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