Stimulus Packages and its Effects

In response to the COVID-19 crisis, governments around the world have introduced huge stimulus packages. Should societies be concerned about the short-term and long-term consequences of these policies?

The stimulus package was grounded from Keynesian economics in which the impact of a recession: a persistent deficiency of aggregate demand and can reach a new equilibrium at a lower output, high rate of unemployment and slower growth rates, such as the COVID-19 crisis, can be diminished with an increase in government spending to stimulate economic activity. A stimulus package is a package of economic measures given to workers by the government to spur a floundering economy. It is a coordinated effort to increase government spending along with lower taxes and interest rates to reinvigorate an economy out of a recession/depression. The goal is to increase aggregate demand through increased employment, consumer spending, and investment.

A stimulus package may be in the form of monetary or fiscal stimulus. A monetary stimulus involves reducing interest rates. When interest rates are lowered, there is more incentive to borrow as the cost of borrowing is reduced. This increase in borrowing suggest more money in circulation in the economy and this less incentive to save and more incentive to spend. Lowered interest rates can weaken the exchange rate of a country/currency, therefore leading to an increase in exports causing additional money to enter the economy, encouraging spending and stirring up the economy. If a conventional monetary stimulus does not work, the government can impose an expansionary monetary policy in which the central bank of a country purchases many financial assets, such as bonds, from other financial institutions. The purchase of these bonds in excess increases the reserves held by the financial institutions and consequently facilitates lending. This causes an increase in the money supply in circulation, driving up the price of assets, lowering their yield and thus lowers interest rates. A fiscal stimulus results in tax cuts or increased spending to arouse the economy. When taxes are cut, people have more income at their disposal. An increase in disposable income suggests higher spending to boost economic growth. As government spending increases, more money is injected which decreases the unemployment rate, increases spending, and counters the impact of a recession. A disadvantage of this method may result in higher debt-to-GDP ratio and the risk that consumers may hoard money instead of spending it, deeming the stimulus package ineffective. The global financial crisis of 2008, similar to COVID-19 crisis, led to abrupt stimulus packages unveiled by governments. Packages contained tax breaks and spending projects aimed at robust job creation and revival of economies. The economic outlook suggests the possible need for a short-term boost, while the budget outlook indicates that the long-run revenue impact of any stimulus should be limited, the key to a stimulus package should be to maximize the short-term boost at the least long-term cost.

This combination of fiscal and monetary stimulus will have larger multiplier effects on economic activity than raised long-term interest rates. Interest rates on long-term debt remain well below probable growth in nominal gross domestic product. As a result, government debt is unlikely to spontaneously increase, thus eventually raising bond yields and increasing the cost of financing the debt. Although, this form of financing can be dangerous if inflation starts to rise. For example, if supply continues to be constrained while consumers simultaneously receive stimulus packages, aggregate demand would rise in an inflationary notion. In that case, it would be important for fiscal injections to be drawn back or reversed swiftly. Stimulus policies are generally thought to be more successful if they are timely (if they boost spending quickly), targeted (if they achieve a large increase in spending in the short-term at minimal cost to the public purse), and temporary (if the government can withdraw the policy once the economic recovery is secure).

Rather than cutting taxes, an alternative approach to supporting spending on commodities is to introduce or increase subsidies for purchasing those goods. The government might be likely to use these incentives to encourage spending that contributes towards other strategic aims, like carbon neutrality. This is an approach taken in Germany and France, where subsidies are available for those buying electric vehicles.

Wage subsidy policies can act as short term stimulus as they help maintain incomes and jobs, giving people more money to spend. Tax cuts can also be used to incentivise companies to hire more staff or invest and thus increase economic activity. Business advocates have suggested the government should reduce employer insurance contributions for newly hired staff to encourage companies to take on more employees. Germany’s June stimulus package included a guarantee that social security contributions will not exceed 40% of wages until the end of 2021, helping businesses to hire more cheaply and with more certainty.

Another way to put more money into the economy is to increase public spending on infrastructure such as investing in broadband, transport or public housing. This stimulates the economy in the short-term by using up otherwise unused capacity in these industries, while also hopefully providing a productivity boost in the long term by ensuring workers waste less time travelling, or can work more efficiently using better internet. Canada has created a special fund allocating government funding on condition that infrastructure projects are completed by the end of 2021. This is an attempt to address problems with using infrastructure as a stimulus; projects take too long to get started, and do not create jobs or help businesses fast enough to contribute to the recovery.

A potential disadvantage includes the crowding out effect which states as public sector spending rise, private sector spending reduces or even gets eliminated. Crowding out suggests that the government deficit spending will reduce private investment in mainly two ways. The increasing demand for labor will raise wages, which negatively impacts business profits. In addition, deficits must be funded in the short run by debt, which will cause a marginal increase in interest rates, increasing costs for businesses to obtain financing necessary for their own investments. The crowding-out effect revolves around the idea that people respond to economic incentives. Because of this, stakeholders will adjust their behavior in ways that offset and cancel out the stimulus policy accordingly. The response to the stimulus will not be a simple multiplier effect, but will also include offsetting behaviors.

In the long term, stimulus may be counterproductive to healing and adjusting the markets. This is especially a problem when stimulus spending is targeted at boosting the industries that are hardest hit by depression/recession. These are the areas of the economy that need to be liquidated in order to adjust to real economic conditions. Stimulus spending boosts areas to run the risk of dragging out a recession by creating economic ‘zombie’ businesses and industries that continue to consume and waste society’s scarce resources as long as they continue to operate. This means that not only will economic stimulus not help the economy get out of recession, but it could make matters worse. Other arguments include practical challenges. Stimulus spending in different nations may occur at the wrong time due to delays in identifying and allocating funds. Central governments are often less efficient at long term allocation of capital to its most useful purpose, thus leading to wasteful and inefficient projects that have lower returns.

This crisis comes is at a time where long term inflation expectations are well anchored at inflation targets. Lower oil prices, in the short term, are also helping to hold inflation down for the moment. Both of these allow more margin for a temporary inflationary impact from the stimulus. Demand for many goods has dropped sharply as customers prefer to remain at home. Business inventories are rising as consumer spending falls amid soaring unemployment. In the first half of the year, it’s likely that gross domestic product growth will decline at its fastest pace since the Great Depression in the 1930s. Governments are providing relief to build a bridge between the current economic downturn and the potential recovery. The goal is to bridge this gap created by the downturn. Referred to as the “output gap,” it’s the difference between the economy’s potential growth rate and its actual growth rate. In order to generate inflation, the gap would need to close and growth would need to exceed its potential for an extended period of time.

The introduction and implementation of stimulus packages in this crisis will have large effects on the economy and people in the nation. An attempt to reinvigorate the fallen global economy will have several pros and cons in short and long term on various stakeholders. This Keynesian concept involves monetary or fiscal stimulus to increase aggregate demand in a time of a recession, causing several other potential effects like inflation, crowding out and inefficiency.

Bibliography

Chappelow, Jim. “Economic Stimulus.” Investopedia, Investopedia, 27 Apr. 2020, www.investopedia.com/terms/e/economic-stimulus.asp.

Dalton, Grant, and Thomas Pope. Stimulus Policies after the Coronavirus Shutdown, The Institute, 7 July 2020, www.instituteforgovernment.org.uk/explainers/stimulus-policies-after-coronavirus-shutdown.

Davies, Gavyn. Can the World Afford Fiscal and Monetary Stimulus on This Scale? Financial Times, 29 Mar. 2020, www.ft.com/content/0f289d20-6e97-11ea-89df-41bea055720b.

Hayes, Adam. “Stimulus Package.” Investopedia, Investopedia, 22 July 2020, www.investopedia.com/terms/s/stimulus-package.asp.