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What Kind of Stimulus?


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In the aftermath of the terror attack on the World Trade Center on September 11, 2001, what kind of a fiscal stimulus package is desirable? The attack caused a fall in consumer confidence: consumers have cut back on their spending on durables. It also caused a fall in businesses’ willingness to invest: many businesses are cutting back on investment and other spending as they wait to learn more about what the future will be. The Federal Reserve does not have much room to lower interest rates further, and it is uncertain how effective interest rate reductions will be in boosting investment spending next year. So there may be a need for a fiscal stimulus package to keep the current recession from becoming a deep one.

Then again, there may not be a need. How large are these shifts? Nobody knows. Everybody agrees that these consequences of the terror attack have shifted the IS curve back to the left. Nobody knows by how far—nobody knows what the position of the IS curve next summer will be. However, any policy changes that the government wants to put in place to affect the state of the economy in late 2002 need to be put into place now, or they will not have time to have an impact on the state of the economy until 2003. Thus the Congress and the President have to decide now whether to enact a stimulus, long before they have the information they really need. And the President and the Congress have to decide as well what kind of stimulus is needed: a government spending increase or a tax cut.

Effects of Different Types of Fiscal Stimulus

If a stimulus package does turn out to be needed, what kind of stimulus is best turns on three considerations:

The answer to the first question is that government spending has a bigger bang for the buck than tax cuts. Government spending shifts the IS curve to the right by an amount equal to the multiplier times the increase in government purchases. Tax cuts shift the IS curve to the right by an amount equal to the multiplier times the marginal propensity to consume times the tax cut. Only if the marginal propensity to consume is high will a tax cut be in the same ballpark as a spending increase.

The answer to the second question is more mixed. Spending that quickly delivers money to households that are liquidity constrained--like a boost to unemployment insurance--will work more quickly than an increase in spending on, say, government infrastructure projects. However a tax cut that delivers money to households with ample current savings will increase their consumption by a small amount for a long time, and hence will work especially slowly.

Only on the last question does the tax cut have a clear advantage. What households buy with the money they receive from a tax cut is what they want and value most. What the government spends money on depends on the political process, and can be high-value public goods (if the political process works well) or low-value "pork-barrel" spending (if the political process works less well).

Previous Handouts

2001-10-21: Federal Reserve Reaction to the Terror Attack on the World Trade Center (Chapter 13: Stabilization Policy. Chapter 10: The IS Curve.)
2001-10-14: Why a Stimulus Package Might Be Desireable (Chapter 13: Stabilization Policy. Chapter 10: The IS Curve.)

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