What Is an Economic Stimulus?

An economic stimulus occurs when a federal government attempts to use targeted monetary or fiscal policies to stimulate an economy (especially when it enters a recession or depression).

How Does an Economic Stimulus Work?

Sometimes referred to as “priming the pump”, an economic stimulus is thought to revive a stagnant economy. If you’ve ever worked an old-fashioned well pump, you’ll know that you have to pump the handle a few times to get the water moving up the pipe and out of the ground.

Both fiscal and monetary policies seek to stimulate the economy by encouraging spending, either at the federal level (through government spending) or at the consumer level by increasing disposable income through tax cuts or interest rate cuts.

The two main ways that a government can implement an economic stimulus is through expansionary monetary policies or expansionary fiscal policies.

Fiscal Policy Decisions

During times of severe economic downturn, the US President may recommend tax cuts. The Constitution of the United States says that “all bills for raising revenue shall originate in the House of Representatives' and that 'Congress shall have the power to lay and collect taxes.' Therefore, presidents can recommend changes to fiscal policies, but only Congress has the power to authorize them.

Monetary Policy Decisions

The Federal Reserve (also known as “the Fed”) manages monetary policy in the United States. The Federal Open Market Committee – consisting of the Federal Reserve Board and the five Federal Reserve Bank Presidents – has the power to determine interest rates and the level of the money supply in the United States.

Examples of Fiscal and Monetary Policy

Fiscal policies include:

  • Tax cuts, which increases disposable income

  • Increases in government spending, which increases aggregate demand in the economy

Monetary policies include:

  • Depreciating the currency thus lowering the exchange rate and making exports more attractive to foreign businesses and consumers

  • Reducing interest interest rates to lower borrowing costs for businesses and consumers

Until recently, fiscal policies – or the change in taxation or government spending – were employed more frequently than expansionary monetary policies.

There’s a great deal of controversy around the effectiveness of using economic stimulus to prompt a response from the economy. Keynesian economists believe that an increase in government spending will eventually lead to higher total output, which will generate greater national income.

Others disagree, citing the Works Project Administration (WPA) during the Great Depression as a failed example of government spending. Although some believe that various infrastructure projects helped the US start to pull out of the Great Depression, others believe that the start of World War II ended the Great Depression by increasing the demand for goods worldwide and, thus, employment opportunities.

How Do Lower Interest Rates Stimulate the Economy?

For businesses, reduced borrowing costs make investment projects more attractive. Consider the example of a manufacturing business conducting a cost-benefit analysis to build a new factory. If the interest rates are high, the costs may outweigh the benefits. As interest rates fall, however, the investment offers the potential for higher profit (and is more likely to be undertaken).

For individual consumers, lower interest rates reduce monthly payments on mortgages, car loans, students loans, and other consumer debts. This frees up disposable income which can be spent on other items.

The 2020 COVID-19 Economic Stimulus Package

The current COVID-19 situation prompted the federal government to engage in economic stimulus. On March 27, 2020, President Trump signed a $2 trillion economic relief package: The Coronavirus Aid, Relief, and Economic Security (CARES) Act.

The CARES Act includes:

  • Economic Impact Payments

  • Social Security Tax Deferral

  • Employee Retention Credit

  • Paycheck Protection Program

Economic Impact Payments

Economic Impact Payments are direct payments of $1,200 per person made to individual citizens (“stimulus checks”).

Social Security Tax Deferral

Under the Tax Deferral portion of the CARES Act, businesses may elect to defer payment of their Social Security taxes due. They may repay 50% of the taxes due by December 31, 2021. The balance must be paid by December 31, 2022.

Employee Retention Credit

The Employee Retention Credit is a tax credit given to employers who suspend in full (or in part) their business and/or experience a significant drop in gross receipts. Full details of the tax credit may be found on the IRS site and employers may request an advance credit using IRS Form 7200.

Paycheck Protection Program

The Paycheck Protection Program is administered through the Small Business Administration and is intended to help small businesses retain employees during the COVID-19 crisis.

The PPP is a loan but it can be forgiven if employers keep their workers on payroll for 8 weeks. The loan is used to fund payroll and necessary expenses such as rent, mortgage interest, utilities, and payroll. Businesses may apply for the loan through an existing SBA (7) lender, a federally insured depository institution, a federal insured credit union, or a Farm Credit System Institution.

The Economic Stimulus Act of 2008

The Economic Stimulus Act of 2008 was intended to ease the economic downturn brought about by the Housing Bubble of 2006-2007 (which precipitated a severe economic collapse).

The Act – which was the government’s attempt to use fiscal stimulus – provided financial relief for individuals as well as incentives for renewable energy, infrastructure development, healthcare, educational institutions, scientific research, and small businesses. Approximately 80% of the tax cuts went to individuals.

At the same time, the Fed instituted stimulative monetary policies by significantly lowering interest rates and engaging in quantitative easing. Quantitative easing is the practice of buying securities, Treasury and corporate bonds, as well as mortgage-backed securities in order to increase the money supply.

Criticism of Economic Stimulus

Critics often cite that economic stimulus packages fail to provide adequate cash injection into the economy to make much of a notable difference. Others say that in a free market, individual behavior (rather than government policy) drives the economy. During uncertain economic times, elements like tax cuts may not have much of an effect on aggregate demand. People may choose to save the money provided by the tax cut rather than spending it.

Lastly, economic stimulus is, after all, an artificial stimulus to the economy. Higher gvernment spending cannot be sustained long-term because it increases the debt to GDP. The World Bank found that when a country reaches a debt-to-GDP ratio of 77%, each additional percentage point of debt costs the economy .017 percentage points of annual real growth. Therefore, the long-term effect of fiscal stimulus may be to slow the economy instead of stimulating it.