Readers Question Can a fiscal stimulus package reduce the extent of the recession?
Fiscal stimulus involves a combination of lower tax cuts and higher spending. In theory the tax cuts will increase disposable income and therefore encourage consumer spending, leading to higher aggregate demand and economic growth. Fiscal stimulus is typically financed by higher government borrowing.
Diagram of Increased AD
For example, in 2010 the UK cut VAT 2.5%. This means that people will pay £12.4 billion less Vat. That is a pretty substantial tax cuts. But will it increase spending.
- People might want to save the extra disposable income
- Falling house prices might outweigh the tax cuts.
- It takes time for people to respond.
- Credit crunch is causing sharp fall in lending and normal business activity.
Therefore, consumer spending may continue to fall. (But, fall at a slower rate – rather than fall by 3% it might fall by 2%)
However, on the other hand in the UK, the tax cuts are being met with
- lower interest rates
- falling pound.
Both of these should help increase aggregate demand
Fiscal policy can help to reduce the extent of a recession. It may not solve the recession straightaway, it may take time, but, it may mean the recession is shorter lived and not as steep. Also, since inflationary pressures are falling away, the inflation impact of expansionary fiscal policy is not so bad.
It will leave us with a record level of government borrowing (8% of GDP) over £110bn.
Effectiveness of Fiscal Stimulus
- Who gains from stimulus? E.g. some people (poor) have a higher marginal propensity to consumer. See: Post on best form of stimulus
- Confidence. Fiscal stimulus may increase confidence in the economy and encourage spending and investment. However, others argue that higher borrowing may cause people to worry about size of debt and actually cut back on spending in anticipation of future tax increases to pay off debt. Confidence and Stimulus
- Monetary Policy. Fiscal policy is more effective if monetary policy is working in tandem. For example, if the government pursue fiscal stimulus but there is falling money supply, this may counter the impact of fiscal stimulus.
- Global Economy. In a global downturn, it will be harder to exit the recession.
- Reaction of bond market. Stimulus requires higher borrowing. If markets are keen to buy bonds, interest rates can stay low (even fall). However, if markets become concerned about future liquidity (e.g. in Eurozone) then bond yields may rise making borrowing more expensive, and the government may be pressured to cut back on stimulus.