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Monday, January 14, 2008

Fiscal Policy in Response to Economic Downturns, Pt. 2: Getting the Most Out of a Fiscal Stimulus Dollar

In Part 1 of this series on economic stimulus fiscal policy, I defined what fiscal policy is and why policy makers would use it during an economic downturn.

Today, I discuss "the multiplier process." The multiplier process is the reason that not all fiscal policies are the same - some are more effective than others at jump-starting a faltering economy. In short, the multiplier effect is the phenomenon by which a dollar injected into the economy (in this case, through fiscal policy) replaces more (and sometimes less) than a dollar of reduced aggregate demand.

Consider the following: Mary receives a check for a $1000 from the IRS in the form of a tax rebate. Based on her on her proclivities and financial situation, she will spend some portion of the rebate while saving the remainder. This is known as her marginal propensity to consume. Let's say Mary's marginal propensity to consume is 90 percent. So, in this example, Mary spends $900 at her favorite local hardware store on new fixtures and paint to remodel her bathroom.

That $900 becomes income for the proprietor of the hardware store. He, in turn, like Mary will save 10 percent and spend 90 percent. Let's say that our hardware store owner has been eyeing a new bicycle in the window of the bike store down the street that costs $810, and with his new-found income he decides to buy it. And like the first transaction, that second transaction becomes someone else's income. In this case, $810 is new income for the bike store proprietor, which in turn becomes an additional $729 (90 percent) of new demand in the economy.

In our example, that $1,000 check turned into $2,430 in fiscal stimulus ($900 + $810 + $729). Now imagine, if you will, $100 billion injected into the economy through tax cuts or spending increases (like in the form of unemployment insurance or food stamps). After the multiplier process takes effect, some not-insignificant increase in aggregate demand ripples through the economy ultimately producing jobs (or at least saving some that would have otherwise been cut) whle giving a boost in income to families teetering on the edge of financial collapse.

Here's where one of the Three Ts of good fiscal stimulus - targeted - comes in (timely and temporary are the other two Ts). For any given tax cut or increase in a spending program, there is a different group of economic actors that will receive the benefit with each group having a different marginal propensity to consume. You can imagine that for individuals with loads of cash on hand, only a tiny fraction of a $1,000 tax rebate will be spent, while low- and even moderate-income individuals probably have a greater need for a tax rebate.

It turns out that data exist on how effective various forms of spending and tax cuts are at stimulating the economy. A recent report by the Center on Budget and Policy Priorities details the findings of Mark M. Zandi's report, "Assessing President Bush's Fiscal Policies". Zandi found the following:

Clearly, some policies are more effective at generating the desired result of stimulating the economy. And given the $3 trillion in additional debt resulting from the Bush Administration's fiscal policies, squeezing every last drop of fiscal stimulus from every deficit-generating dollar is particularly important for Congress to consider as they debate economic stimulus packages.

In Part 3, I will discuss why any fiscal stimulus should be temporary