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What is an Economic Stimulus Package?

August 02, 2021 · 5 minute read

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What is an Economic Stimulus Package?

An economic stimulus package is a set of financial measures put together by central bankers or government lawmakers with the aim of improving, or “stimulating,” an economy that’s struggling.

Individuals in the US during the past two decades have witnessed two major periods when stimulus packages were used to boost the economy: first, after the 2008 financial crisis, and second, following the 2020 outbreak of the Covid-19 pandemic.

While viewed by some as key to reviving growth, economic stimulus packages are not without controversy. Here’s a closer look into how they work, the different types of stimulus packages, as well as their pros and cons.

Economic Stimulus Packages, Explained

The foundational theory behind these economic stimulus packages—whether it’s the Roosevelt, Obama or Trump stimulus package—is one developed by a man named John Maynard Keynes in the 1930s.

Keynes was a British economist who created his theory in response to the global depression of the era. His conclusion was that, when a government lowers taxes and increases its spending, this would stimulate demand and help to get the economy out of its depressed state.

More specifically, when taxes are lowered, this helps to free up more income for people; because more is at their disposal, this is referred to as “disposable income.” People are more likely to spend some of this extra money, which helps to boost a sluggish economy.

When the government boosts its spending, this also puts more money into the economy. The hoped-for results are a decreased unemployment rate that will help to improve the overall economy.

Economic theory, of course, is much more complex than that, and so are stimulus packages. Here’s more about different forms of these economic strategies.

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Different Types of Stimulus

Monetary Stimulus

To get a bit more nuanced, monetary stimulus is something that occurs when monetary policy is changed to boost the economy.

Monetary policy, meanwhile, is how the supply of money is influenced and interest rates managed through actions taken by a central agency. In the U.S., that agency is the Federal Reserve Bank.

Ways in which the Federal Reserve can use monetary policy to stimulate the economy include cutting policy rates, which in turn allows banks to loan money to consumers at lower rates; reducing the reserve requirement ratio, and buying government securities.

When the reserve requirement ratio is lowered, then banks don’t need to keep as much in reserve—which means they have more to lend, at lower interest rates, which makes it more appealing for people to borrow money and get it circulating in the economy.

Fiscal Stimulus

Fiscal stimulus strategies focus on lowering taxes and/or boosting government spending. When taxes are lowered, this increases the amount of money that people have left over from a paycheck, and that money could be spent or invested.

When money is spent on a greater amount of products, this increases demand for those products—which in turn helps to reduce unemployment because companies need more employees to make and sell them.

If this process continues, then employees themselves become more in demand, which makes it more likely that they can get higher wages—which gives them even more funds to spend or invest.

When the government spends more money, this can increase employment, giving workers more money to spend, which can increase demand—and so, it is hoped, the upward cycle continues.

In the US, a federal fiscal package needs to be passed by the Senate and the House of Representatives—and then the president can sign it into law.

Quantitative Easing

Quantitative easing (QE) is a strategy used by the Federal Reserve when there is a need for a rapid increase in the money supply in the United States and to boost the economy.

For example, on March 15, 2020, the Federal Reserve announced a $700+ billion program in response to COVID-19. In general, QE involves the Federal Reserve buying longer-term government bonds, among other assets.

Pros and Cons of Stimulus Packages

The goal of a stimulus package, based on Keynesian theory, is to revive a lagging economy and to prevent or reverse a recession, where the economy is retracting rather than expanding. This is a more immediate form of relief as the government also uses monetary, fiscal, and QE strategies to boost the overall economy.

An economic theory that runs counter to Keynesian theory is the crowding out critique. According to this thinking, when the government participates in a deficit form of spending, labor demands will rise, which leads to higher wages, which leads to lower bottom lines for businesses.

Plus, these deficits are initially funded by debt, which causes an incremental increase in interest rates. This means it would cost more for businesses to obtain financing.

Other criticisms of stimulus spending focus on the timing of when funds are allocated and that central governments can be less efficient at capital allocation, which ultimately leads to waste and a low return on spending.

Another risk is that the central bank or government over-stimulates the economy or prints too much fiat currency, leading to inflation, or rise in prices. While a degree of inflation is normal and healthy for a growing inflation, price increases that are rapid and out of control can be painful for consumers.

Recommended: What Exactly is a Recession?

Previous Economic Stimulus Legislation

Perhaps the most sweeping stimulus bill ever created in the United States was signed into law by President Franklin Delano Roosevelt on April 8, 1935.

Called the Emergency Relief Appropriation Act and designed to help people struggling under the Great Depression, Roosevelt simply called it the “Big Bill”; it is now often referred to as the “New Deal.” Five billion dollars was provided to create jobs for Americans, who in turn built roads, bridges, parks, and more.

The Works Progress Administration (WPA) came out of the New Deal, ultimately employing 11 million workers to build San Francisco’s Golden Gate Bridge, LaGuardia Airport in New York, Chicago’s Lake Shore Drive, about 100,000 other bridges, 8,000 parks, and half a million miles of roads, including highways.

Another agency, the Tennessee Valley Authority, collaborated with other agencies to build more than 20 dams, which generated electricity for millions of families in the South and West.

More Recent Stimulus Packages

Additionally, there was the American Recovery and Reinvestment Act (ARRA) in 2009. This was passed into law in response to the Great Recession of 2008 and is sometimes called the “Obama stimulus” or the “stimulus package of 2009.” Its goal was to address job losses.

This Act included $787 billion in tax cuts and credits, as well as unemployment benefits for families. Dollars were also provided for infrastructure, health care, and education, and the total funding was later increased to $831 billion.

Most recently, the Coronavirus Aid, Relief and Economic Security Act, or the CARES Act, was passed by the United States Senate on March 25, 2020. On March 27, 2020, the House of Representatives passed the legislation and the President signed it into law the same day.

Recommended: What’s In the Covid-19 Stimulus Package?

The Takeaway

Stimulus packages are used to prop up economies when they are struggling or on the brink of a major recession, or even depression. While in recent decades, such stimulus packages have been credited by some for helping the US economy out of the 2008 financial crisis and 2020 Covid-19 pandemic, others worry that the increase in government deficit is unhealthy, and all that spending could lead to inflation.

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