How is economic stimulus supposed to work?

By Kerk Phillips

Deseret News

Published: Monday, Oct. 31 2011 7:00 p.m. MDT

U.S. President Barack Obama signs an economic stimulus package into law inside the Museum of Nature and Science in Denver, Colorado, U.S., on Tuesday, Feb. 17, 2009. Obama signed into law one of the biggest economic rescue efforts in U.S. history, a $787 billion stimulus bill that he says will restore some of the jobs lost in the recession and secure future U.S. growth.

Associated Press

In February of 2009, Congress passed and President Barack Obama signed the American Recovery and Reinvestment Act.

At the time it carried an estimated price tag of $787 billion. Commonly referred to as "the stimulus bill," it was intended to reinvigorate an economy battered by the subprime mortgage financial crisis.

In September of this year, the president proposed the American Jobs Act, which is also intended to invigorate the economy and spur jobs creation. Under this act, an additional $447 billion will be spent, leading some people to refer to it as "Stimulus Jr."

How exactly is increased government spending supposed to stimulate the economy. The basis for this prescription lies in a particular school of macroeconomic thought known as Keynesianism.

The name comes from the famous British economist, John Maynard Keynes. When he came up with his theories, Keynes had in mind an economy mired in recession or depression, as was the case around the world during the 1930s. In this environment, Keynes claimed that workers and firms stood ready and willing to produce goods at the prevailing prices, if only someone would buy them.

This is the description of a market surplus, which occurs in individual markets occasionally for a variety of reasons. Keynes argued there was an economy-wide surplus of goods, not just a surplus in a few scattered markets.

Normally with surpluses, markets respond by lowering prices to clear the market, so that all goods offered for sale are purchased. Think of sales on day-old bread or DVDs in the discount rack and you get the idea. However, Keynesian theory postulates that prices are slow to adjust, particularly downward. This is referred to as price "stickiness," and it implies that markets will remain in surplus for long periods of time.

In the long run, prices will eventually fall and markets will clear, but as Keynes famously quipped, "In the long run we are all dead." Hence, we may be quite concerned about what happens in the short run while prices are not adjusting.

In this scenario, the problem with the economy is coming from consumers on the demand side. They are not spending enough to purchase all the goods offered for sale.

A Keynesian prescription is to let the government purchase goods and services instead. In theory this increases the demand for goods. Firms sell goods that would otherwise remain unsold or not even produced in the first place. And workers go back to work producing those goods.

There are complications, however. The government needs to get the money to pay for these purchases somehow. If it raises taxes, and uses the increased revenue to buy goods, it is also lowering the income of the households and businesses it taxes. As a result, they spend less as the government spends more.

Whether this leads to a net increase in the demand for goods depends on whether those taxes reduce their consumption of goods by more or less than the government increases its consumption. Economists call this the marginal propensity to consume or MPC and argue that the MPC of the government is close to 100 percent (at least for stimulus spending) while the MPC of consumers in less than that.

Hence, a stimulus increases government spending more than it depresses private spending and yields a net increase in demand.

If, however, the government pays for spending by running a deficit, private spending need not fall, because households are not taxed and need not reduce spending. This reasoning is why the traditional Keynesian policy prescription is to stimulate via deficit spending in a recession.

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