Originally published on 01/14/2009

Here’s the logic behind the fiscal stimulus. Because of falling wealth levels and rising unemployment, household and business demand for goods and services is falling. Instead of spending money as quickly as they once did, households save more, either keeping more currency at home or maintaining larger bank balances. In normal times, any money deposited in banks is lent out (mostly) to other households and businesses who wish to spend more for the moment. If there isn’t enough demand for bank loans, banks will lower the interest rate to stimulate the extra demand. However, today, banks are more afraid to lend to others because they are worried that many households and businesses will become insolvent and be unable to repay the loans in the future.

Thus, the circulation of money – what’s known as money velocity – from businesses to households and back to businesses is slowed. One way to get things moving again is to pump more money into the system. This is what the FED has already done with expansionary monetary policy and lower interest rates. However, if much of the extra money the FED has pumped in is simply held onto by households, businesses and banks then demand for goods and services continues to stagnate. It does no good.

However if the government comes along in a period of slowed private demand and substitutes for that demand with extra government demand for goods and services, then presumably GDP can be maintained at near current levels. In other words, suppose for every dollar that is not spent by households, the government demands one extra dollar of goods or services, then total demand in the economy is maintained. Businesses could then continue producing at previous levels and they would not need to lay off workers. Hence by quickly substituting government demand for the declining household demand, GDP and employment is kept near the original level and a severe recession can be prevented.

That’s the logic at least. The next post will highlight some problems that could make a fiscal stimulus possibly not so effective.