Fiscal Stimulus Vs. Economic Growth

For most experts, a key factor that policymakers should be watching is the ratio between actual real output and potential real output. The potential output is the maximum output that the economy could attain if all resources are used efficiently. In Q3 2020, the US real GDP–to–potential US real GDP ratio stood at 0.965 against 1.01 in Q3 2019.

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potential real gdp

A strong ratio (above 1) can be of concern because according to experts it can set in motion inflationary pressures. To prevent the possible escalation of inflation, experts tend to recommend tighter monetary and fiscal policies. Their preferred policy would be to soften aggregate demand, which is considered as the key driving factor behind the ratio’s rise above 1.

However, a greater concern to most experts is if the ratio falls below 1, which is associated with an economic slump. Most commentators are of the view that with the emergence of a ratio below 1, the most effective policy to lift the ratio is by means of aggressive fiscal stimulus, i.e., the lowering of taxes and increasing government outlays—a policy of large government deficit.

This way of thinking follows the ideas of John Maynard Keynes. Briefly, Keynes held that one could not have complete trust in a market economy, which is inherently unstable. If left free, the market economy could lead to self-destruction.

Hence, there is the need for governments and central banks to manage the economy. Successful management in the Keynesian framework can be achieved by influencing the overall spending in an economy. It is spending that generates income. Spending by one individual becomes income for another individual according to the Keynesian framework.

What ultimately drives the economy, then, is spending. If during a recession consumers fail to spend, then it is the role of the government to step in and boost overall spending in order to grow the economy.

If for whatever reason the demand for the goods produced is not strong enough, this could lead to an economic slump. (Inadequate demand for goods leads to only a partial use of existent labor and capital goods.) What is overlooked in this way of thinking is the importance of savings in funding real economic growth. In fact, savings are regarded as detrimental to economic growth in this way of thinking.

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