Mom asks: What’s monetary and fiscal stimulus?

(When my mom – ex middle school science & economics teacher – asks about monetary and fiscal stimulus)

When does an economy grow?
At a simple level, when earning/spending increases.
People and companies spend more when they have more money.
They get more money from increased borrowing, or increased income.

The government, when confronting low inflation and low growth, wants to increase this spending.
It has two sets of tools – monetary and fiscal – to stimulate this growth.

Monetary tools target increased lending/borrowing, and fiscal tools intend to increase income directly.

Fiscal stimulus

Fiscal policy means the government spends money in form of, usually, infrastructure projects. This direct spending then creates extra income (and demand) in the economy, which leads to more spending, and so on.
It also has a knock on effect of improving infrastructure, and hence the productivity of the economy.

For a long time in the post war period (1950-), this fiscal stimulus was the preferred method. It was also called Keynesian economics.

One downside of this fiscal stimulus is that the government has to borrow money to spend, which
a) increases government’s debt and creates imbalanced budgets, and
b) displaces private borrowing – government borrowing, to spend, potentially increasing borrowing cost for companies & people.

The assumption behind the fiscal stimulus is that the increased growth will increase incomes, which will result in an increase in tax collections, which the government can use to reduce its debt.

Monetary stimulus

Under monetary stimulus, the government (or its reserve bank), releases more money for the banks. It hopes that banks will lend this extra money to people and companies, who will spend it, and fuel the growth cycle.

Why will banks lend this money? Because that’s how they make money – interests and fees on loans. Otherwise, increased cash + same loans = their returns as a ratio will reduce.

The monetary stimulus, by releasing money for the banks, enhances private borrowing instead of displacing it. Also, by lowering interest rates on savings, it incentivizes savers to instead spend their money.

Sadly, the monetary stimulus method too has its limitations…
a) there is only so much safe lending banks can do, without substantially increasing risks, and
b) there is only so much lower that the interest rates can go.

The current zero, close to zero, and even negative interest rates are an outcome of years of monetary easing around the developed world.

So, once there’s no more lending to be done, and no more lowering of interest rates, the capacity of monetary stimulus runs out. The next option for growth is again just fiscal spending.

Which is what many big, developed economies around the world are now considering.


Not covered

India, middle-income trap, politics of Keynesian vs Chicago school of economics, effect of oil & commodities, China, Euro, and what happens if everything fails (a.k.a. Japan)

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