Economic Stimulus: What It Is And How It Works

Economic shocks make governments do all sorts of things to try to correct for a situation and get back on course. When they do this, it’s referred to as economic stimulus. The COVID-19 pandemic was a perfect example of when the U.S. government and others have stepped in to try to stabilize the economy through some measures of their own.

Within this article, we’ll go over what economic stimulus is, why governments didn’t always act on the economy in the way they do now, how it works and some of the pros and cons.

What Is Economic Stimulus?

Economic stimulus is a combination of government and central banking policies – known as fiscal and monetary policy, respectively – which are designed to kick-start the economy.

Stimulus can include everything from tax cuts and credits to direct checks going into people’s bank accounts on the fiscal policy side. When it comes to monetary policy, central banks will do things like lower interest rates and print more money, in a controlled manner, to encourage spending.

The ultimate goal of all of this is to make it easier for people to borrow and spend money. Spending money leads to an increased need for the production of goods and services, which leads to more hiring, which leads to more people being able to spend money to purchase more goods and services in a virtuous cycle of capitalism.

Economic stimulus is typically employed to combat the effects of a recession in order to get people back to work and put money in their pockets. The idea goes back to theories proposed by the economist John Maynard Keynes and popularized during the Great Depression of the 1930s.

Up to that point in history, the prevailing sentiment among experts was based on Say’s Law. Say’s Law states that demand is tied to past economic production. This led to the theory that supply and demand should always be in balance. One of the widely held beliefs at the time was that if there was a recession it’s because wages were too high and businesses could no longer hire.

However, followers of Keynesian economics argued that hiring back at lower wages just gives people less money to buy things. It doesn’t really give you a boost out of a recession. For that boost, you need government intervention, he argued. Thus, stimulus was born as one of the tools of government.

Economic Stimulus Package Definition

An economic stimulus package is a series of monetary and fiscal policy measures intended to revitalize economic output. Typically, monetary and fiscal policy initiatives are undertaken in tandem.

In the U.S., stimulus packages are passed like any other law. Bills pass the House of Representatives and Senate. In some cases, separate bills move through in tandem and in others, one chamber sends it to the other. If there are differences between the House and Senate versions, there is a reconciliation process, and that version of the bill is voted on by both chambers before being sent to the President for his signature. If the bill is signed, it takes effect. If the President vetoes, that decision can be overridden by a two-thirds majority of both chambers.

Once it’s through the legislative and executive branches, the only time the judicial branch gets involved is if there is a challenge to the constitutionality of the law.

How Does A Government Stimulate The Economy?

Governments generally have two tools for stimulating the economy: fiscal and monetary policy. Let's dig into these in a bit more depth.

Fiscal Stimulus

Fiscal stimulus involves things a government can do by passing laws or executive orders. Fiscal policy actions taken to stimulate the economy may include lowering taxes or engaging in deficit spending. Deficit spending occurs when a government takes on additional debt in order to fund initiatives to employ people, or a government directly deposits money to constituents through stimulus checks.

In response to the COVID-19 pandemic, Congress first passed the CARES Act. Among other provisions, this act temporarily increased the level of unemployment benefits and expanded unemployment to some groups that would ordinarily be ineligible as independent contractors. Additionally, there were economic impact payments given to Americans below a certain income threshold. There were three rounds of these payments, including one from the American Rescue Plan that we’ll discuss next.

If you were eligible but didn’t receive all or a portion of any of the economic impact payments, you can claim the 2021 Recovery Rebate Credit on your taxes.

In addition to an economic impact payment, the Child Tax Credit was increased and expanded as part of the American Rescue Plan. And, the IRS made advance payments from July – December 2021 in monthly installments so that people could benefit from the extra support money immediately rather than having to wait to claim the credit.

Monetary Stimulus

From the monetary side, a central bank like the Federal Reserve can lower interest rates for banks within a country. When they do this, the idea is that borrowing is made cheaper for banks and those savings are passed on to consumers in the form of lower interest rates. Other tools can be used as well. With the blessing of Congress, the Fed set up new lending programs during the COVID-19 pandemic including the Main Street Lending Program.

Pros And Cons Of Government Stimulus

Government stimulus has both benefits and potential drawbacks. Let’s run through them!

Pros

Among the upsides are the following:

• Consumer friendly: At the outset, some of the general things common to government stimulus (including direct checks and a lower tax bill) tend to be very popular. Who doesn’t like more money in their pocket?
• Economic boost: if you look at the retail sales reports for the months right after each of the stimulus checks hit many Americans’ bank accounts, sales were way up. Given that, we know that if you give people money to spend, they will use it to buy goods and services. This creates more demand and forces businesses to hire additional employees. The government has the ability to create jobs programs as it did with the Civilian Conservation Corps after the Great Depression.

Cons

There are a few downsides as well. These include:

• National debt: The national debt ends up rising if you borrow more money to make your stimulus projects possible. This can be viewed as worth it if the economy gets enough of a jump-start and things end up being on the right track. However, the bill does eventually come due. Right now, interest rates are low, so that helps.
• Inflation: Any time there’s more money entering the market, there’s the potential for prices to rise. A little bit of inflation isn’t a bad thing because it encourages people to buy now, but you don’t want to wake up tomorrow and have gas be $5 per gallon.
• Timing can be difficult: The amount and timing of stimulus are both crucial. If you do too little, there’s a good chance you’re cutting off support before the economy really gets its footing again. Too much, and you risk causing both inflation and the national debt to rise to unnecessary levels.

The Bottom Line

Economic stimulus refers to efforts by governments to jumpstart the economy and avoid long-term pain caused by a recession. It can include both fiscal and monetary policy measures, like lower taxes and direct stimulus checks on the fiscal side and lower interest rates in terms of monetary policy.

These stimulus packages can really provide the jolt the economy needs and even get people back on the job. On the downside, timing can be difficult and there are risks for increased national debt and inflation.

To learn more about the tools the government has to stimulate or slow down the economy, you may be interested in fiscal vs. monetary policy.