What does an economic stimulus do?

In the last article in this series, I talked about how economic stimulus is supposed to work. The basic premise is that when the government spends more money on goods & services, they more than replace the spending that households would've done without the stimulus. That is the marginal propensity to consume (MPC) of the government is higher than that of households.

Economist Robert Barro has argued for the past thirty years or so, that this simple story ignores important aspects of household reasoning. Imagine for example, that the government decides to run a budget deficit by lowering taxes. This should be stimulative, since it leaves more money in the hands of consumers, who will presumably spend at least some portion of it (based on their MPC). Barro argues, however, that rational households will realize that cutting taxes today and leaving spending unchanged does not mean taxes can stay permanently lower. Such a policy is unsustainable over a long period of time. Forward looking households will realize that lowering taxes today means raising them in the future (holding government spending constant over time in our example). As a result they have a lower tax burden today and higher taxes in the future. Since most consumers prefer consumption that is smoothed out over time, rather than high consumption now and low consumption later, the best behavior is to save. Barro showed that under certain circumstances households increase their savings by exactly the same amount as the government reduced their taxes. This leaves consumption unchanged and hence gives not stimulus at all.

Barro has termed this effect "Ricardian equivalence" based on work by David Ricardo in the 1800's. As mentioned, Ricardian equivalence holds only in certain circumstances. First, all consumers need to be rational and forward looking. If some consumers do not care about the future, they will view a drop in taxes today as an increase in spendable income and increase their consumption. If some consumers do not expect to be alive when the tax increase occurs they will also be likely to increase their consumption. In these cases, there will be a stimulative effect of cutting taxes, even when it must necessarily be a temporary cut.

Similarly, if the government increases spending and does so by borrowing money, rational households will realize that even though taxes don' t rise today, they must eventually rise at some future date. The further off into the future that date is expected to be, the greater the number of households that will expect to be dead when the increase hits. And, hence, the greater the stimulus will be.