Economic stimulus is a mix of government and central bank policies that is designed to energize economic activity when a economy slows down or is in recession. It can include both monetary and fiscal policy measures, though the term is most often associated with the latter. The most common ways to stimulate an economy are through lowering interest rates and increasing government spending, both of which are known as expansionary policies.
Lowering interest rates increases the profitability of additional investments, whereas increased government spending injects new money into the economy. Economists generally consider fiscal policy more effective than monetary because it is more directly targeted at specific groups of the population with differing marginal propensities to consume or invest (such as low-income earners). This type of fiscal stimulus may also be more transparent and less susceptible to public choice theory or corruption.
The effectiveness of stimulus depends on its timing and targeting. When implemented effectively, it can help to revive economies and avoid deeper downturns. However, it can also backfire and lead to inflation or longer-term economic challenges if mismanaged. Stimulus should be timely, targeted, and temporary – quickly reversed once conditions improve.
The most visible channel for fiscal stimulus is cutting income taxes, which frees up disposable money for people to spend. This is particularly effective if it is focused on low-income households, which have a larger marginal propensity to consume. Other types of stimulus can be aimed at businesses to encourage them to hire and invest. This can include tax cuts, or credits such as reduced payroll taxes for small businesses.
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