What Is Economic Stimulus? How It Works, Benefits, and Risks

Economic stimulus is action by the government to encourage private sector economic activity. To stimulate the economy, the government adopts targeted, expansionary policies.

Economic stimulus in the United States may be related to monetary policy carried out by the Federal Reserve. Other forms of economic stimulus are driven by fiscal policy, with lawmakers directing tax policies and government spending toward areas that they believe will jump-start the economy.

Policy tools for implementing economic stimulus include lowering interest rates, increasing government spending, and the purchase of assets by the central bank in a process known as quantitative easing. It is common for the government to adopt stimulus policies during times of recession, but economic stimulus may also be used to provide an additional boost during periods of economic strength.

Although the long-term benefits of such policies remain a subject of debate, the programs put in place to bolster the economy can have a big impact on financial markets and investors. This makes it important to be aware of the mechanisms of economic stimulus as well as the associated benefits and risks.

Key Takeaways

  • Economic stimulus refers to targeted fiscal and monetary policy intended to elicit an economic response from the private sector.
  • Economic stimulus relies on encouraging private sector spending to make up for loss of aggregate demand.
  • Fiscal stimulus measures include deficit spending and lowering taxes. Monetary stimulus measures are produced by central banks and may include lowering interest rates.
  • Economists still argue over the usefulness of coordinated economic stimulus, with some claiming that it can do more long-term harm than short-term good.

How Economic Stimulus Works

Over the course of a normal business cycle, governments try to influence the pace and composition of economic growth using various tools at their disposal. Central governments, including the U.S. federal government, use fiscal and monetary policy tools to stimulate growth. State and local governments can also engage in projects or policies that stimulate private sector investment.

Economic stimulus refers to a targeted and conservative approach to expansionary economic policy. Instead of using monetary and fiscal policy to replace private sector spending, economic stimulus is supposed to direct government deficit spending, tax cuts, lowered interest rates, or new credit creation toward key sectors of the economy to take advantage of powerful multiplier effects that will indirectly increase private sector consumption and investment spending.

Proponents of economic stimulus believe that this increased private sector spending will then boost the economy out of recession. The goal is to achieve this stimulus-response effect so that the private sector can do most of the work to fight the recession and to avoid risks such as hyperinflation or government defaults that might come with massive government deficits or extreme monetary policy. By stimulating private sector growth, stimulus deficit spending could allegedly even pay for itself through higher tax revenues resulting from faster growth.

Fiscal Stimulus vs. Monetary Stimulus

Fiscal stimulus refers to policy measures undertaken by a government that typically reduce taxes or regulations—or increase government spending—to boost economic activity. Monetary stimulus, on the other hand, refers to central bank actions, such as lowering interest rates or purchasing securities in the market, to make it easier or cheaper to borrow and invest. A stimulus package is a coordinated combination of fiscal and monetary measures put together by a government to stimulate a floundering economy.

The concept of economic stimulus is associated with 20th century economist John Maynard Keynes. A recession, according to Keynesian economics, is a deficiency of aggregate demand where the economy will not self-correct and reaches a new equilibrium with higher unemployment, lower output, and slower growth rates. Under this theory, to combat recession, the government should aim to restore aggregate demand and full employment through policies that make up for shortfalls in private sector consumption and business investment spending.

Risks of Economic Stimulus

There are several counterarguments regarding the efficiency and long-term benefits of economic stimulus. Some theorists believe that economic stimulus can actually delay or prevent private sector recovery from the actual cause of a recession. According to this viewpoint, it is misguided to target economic stimulus toward industries that are hardest hit by the recession because these are precisely the areas of the economy that may need to be cut back to adjust to real economic conditions.

Other critiques about the effectiveness of economic stimulus revolve around how people respond to economic incentives. Economists have argued that consumers and businesses adjust their behavior in ways that offset the stimulus policy. The response to the stimulus will not be a simple multiplier effect but will also include these offsetting behaviors. 

One such theory is Ricardian equivalence, named for David Ricardo’s work dating back to the early 1800s, which suggests that consumers internalize government spending decisions in a way that counterbalances stimulus measures. In other words, Ricardo argued that consumers will spend less today if they believe they will pay higher future taxes to cover government deficits.

Other critics of economic stimulus point to the crowding out of private investment. The crowding-out critique suggests that government deficit spending will reduce private investment in two ways:

  1. The rising demand for labor will increase wages, which hurts business profits.
  2. 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.

Examples of Economic Stimulus Programs

Those who have lived through the past few decades have had quite a few chances to see economic stimulus in action. The economic shockwaves from the financial crisis of 2007–2008 and more recently the COVID-19 pandemic forced fiscal and monetary policymakers into action. The programs below represent just a small sampling of government efforts to steer the economy through the respective crises, but they offer some insights into the potential benefits and shortcomings of economic stimulus.

Cash for Clunkers

Policymakers often attempt to direct the benefits of economic stimulus toward specific industries or sectors. When the U.S. auto industry struggled during the Great Recession, the government instituted the Cash for Clunkers program, which incentivized consumers to buy new, fuel-efficient vehicles to replace their old cars. Signed into law by then-President Barack Obama and lasting for a short time frame in the summer of 2009 until its allocated funding was depleted, Cash for Clunkers was intended to be a win-win by stimulating a critical industry during the recession while also reducing pollution.

However, critics argued that Cash for Clunkers led to a used vehicle shortage and higher car prices, with much of the benefit going to foreign car manufacturers. The program succeeded in nudging consumers to trade in their gas guzzlers, but it may have simply pushed forward a transaction that was going to happen anyway, and the economic effect was short-lived. Even the environmental impact was mixed, as the discarded clunkers generated hazardous waste from metal shredding, and the program did not represent a cost-effective way to cut emissions.

Coronavirus Aid, Relief, and Economic Security (CARES) Act

The Coronavirus Aid, Relief, and Economic Security (CARES) Act, signed into law by then-President Donald Trump on March 27, 2020, aimed to counteract the economic turmoil set into motion by the global COVID-19 pandemic. With concerns that the U.S. economy was heading into a recession, policymakers passed a record $2.2 trillion stimulus bill to support large and small businesses, industries, individuals, families, gig workers, independent contractors, and the healthcare system.

The CARES Act took a multifaceted approach to stimulate the ailing economy during the early stages of the pandemic. The legislation put money directly into the pockets of U.S. consumers, authorizing direct stimulus payments of $1,200 per adult plus $500 per child for households making up to $75,000, with additional tax rebates for families with children. The stimulus package also boosted unemployment benefits and helped small businesses hold onto their employees. As far as targeting individual hard-hit industries and sectors, the CARES Act directed billions toward airlines to keep planes in the skies throughout the pandemic.

In addition to standing out for its massive price tag, the CARES Act pushed the boundaries of economic stimulus by directly replacing large swaths of private sector spending that had been destroyed by the coronavirus. While the CARES Act may have been a needed response to the unprecedented economic shock of the pandemic, the long-term impact of the stimulus package remains difficult to quantify.

How Is the Economy Stimulated?

The government can stimulate the economy through targeted, expansionary monetary and fiscal policy. The idea of economic stimulus is that these actions by the government help to jump-start economic activity in the private sector.

Policy tools for stimulating the economy include interest rate cuts, government spending increases, and quantitative easing. Policymakers generally direct stimulus programs toward key economic sectors to take advantage of multiplier effects that they hope will indirectly increase private sector spending.

Is Stimulus Good for the Economy?

Economists continue to debate the usefulness of economic stimulus programs. While stimulus efforts often have short-term benefits of boosting demand and reinvigorating vital economic sectors, the longer-term effects can be more difficult to quantify. For instance, an overstimulated economy could have the unintended consequence of crowding out private sector investment.

How Does Quantitative Easing Stimulate the Economy?

When central banks like the U.S. Federal Reserve opt to engage in quantitative easing, they buy securities from the market to increase the money supply. This means that banks have more reserves on hand, and the increased liquidity revitalizes lending and investing.

The Bottom Line

Economic stimulus can refer to monetary and fiscal policies that governments put in place to energize economic activity in the private sector. Policymakers aim stimulus efforts at critical areas of the economy, with hopes that the multiplier effect will provoke broader economic growth.

There is still plenty of debate surrounding the long-term impact of economic stimulus programs. Proponents argue that targeted economic stimulus can be a vital recession-fighting tool that avoids the risks associated with more drastic measures. Meanwhile, critics say that economic stimulus packages may have unpredictable and negative impacts in the long term.

Article Sources
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