Fiscal stimulus vs economic growth – Dateway

For most experts, a key factor that policy makers should watch out for is the relationship between actual real output and actual potential output.

Potential output is the maximum output that the economy could achieve if all resources are used efficiently. In the third quarter of 2020, the ratio of US real GDP to potential US real GDP stood at 0.965 compared to 1.01 in the third quarter of 2019.

A high ratio (greater than 1) can be of concern because, according to experts, it can trigger inflationary pressures. To avoid a possible escalation in inflation, experts tend to recommend tighter monetary and fiscal policies. Their preferred policy would be to soften aggregate demand, which is seen as the main factor determining the rise in the ratio above 1.

However, most experts are more concerned with whether the ratio falls below 1, which is associated with an economic crisis. Most commentators believe that with the emergence of a ratio of less than 1, the most effective policy to raise the ratio is to resort to aggressive fiscal stimulus, i.e. to cut taxes. and to increase public spending – a policy of large public deficit.

This way of thinking follows the ideas of John Maynard Keynes. In short, Keynes argued that one cannot have complete confidence in a market economy, which is inherently unstable. If left free, the market economy could lead to self-destruction.

Therefore, governments and central banks must manage the economy. Successful management in the Keynesian framework can be achieved by influencing the overall spending in an economy. These are the expenses that generate income. The expenses of one individual become income for another individual according to the Keynesian framework.

What ultimately drives the economy, therefore, are spending. If, during a recession, consumers do not spend, it is the role of government to step in and increase overall spending in order to grow the economy.

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If, for some reason, the demand for the goods produced is not strong enough, it could lead to an economic crisis. (Insufficient demand for goods leads only to partial use of existing labor and capital goods.) What is overlooked in this way of thinking is the importance of saving to finance real economic growth. In fact, saving is seen as detrimental to economic growth in this way of thinking.

Relationship between savings and money

Saving as such has nothing to do with money. It is the quantity of final consumer goods produced in addition to current consumption.

Producers of final consumer goods can exchange saved goods or exchange them for intermediate goods such as raw materials and services. Observe that the safeguarded goods support all stages of production, from the producers of final consumption goods to the producers of raw materials, services and all other intermediate goods.

Support means that these savings allow all producers of these goods to maintain their lives and well-being while they are busy making things. Also note that if the production of final consumer goods were to increase, all other things being equal, it would expand the real savings pool and increase the capacity to produce more of a wider variety of consumer goods, i.e. of wealth.

Note that people do not want means as such but rather final consumer goods. This means that in order to survive, people must have access to consumer goods. It is only once there has been a sufficient increase in the pool of consumer goods that people can seek to improve their well-being by seeking other things such as entertainment and services such as medical treatments, etc.

Without savings, increasing demand is not possible

Note that what matters for economic growth is not only the tools and machines and the reserve of labor, but the adequate flow of final consumer goods that preserves the life and well-being of the community. ‘individual.

For example, a baker produces ten loaves of bread of which he consumes two loaves and exchanges eight loaves for a pair of shoes with a shoemaker. In this example, the baker finances the purchase of shoes with the eight loaves of bread kept.

Note that bread sustains the life and well-being of the shoemaker. Likewise, the shoemaker financed the purchase of bread by means of shoes which maintain the life and well-being of the baker.

Consider that the baker decides to invest in another oven in order to increase the production of bread. In order to implement his plan, the baker calls on the services of the oven manufacturer.

He pays the maker of the oven with some of the bread he produces.

What we have here is a situation where the construction of the oven is financed by the production of a final consumer good: bread. If for some reason the bread production flow is interrupted, the baker will not be able to pay the oven maker. Consequently, the manufacture of the furnace should be discontinued. Now, even if we accept that potential output is greater than real output, it does not follow that increasing public spending will lead to increasing real output of the economy.

It is not possible to increase aggregate output without the necessary support of final consumer goods or the flow of real savings. Note that it is by means of a final consumer good – bread – that the baker has been able to finance the expansion of his production structure.

Likewise, other producers must have final consumer goods saved – real savings – to finance the purchase of the goods and services they need. Note that the use of money does not change the essence of the funding. Money is only the medium of exchange. It is used to facilitate the movement of goods, but it cannot replace final consumer goods.

Once the actual savings are exchanged for money, what the holder of the money actually does is of no consequence. Whether he uses it immediately in exchange for other goods or puts it under the mattress, that won’t change the actual savings pool. The way in which people decide to use their money will only change their demand for money; however, this has nothing to do with real savings.

Individuals can exercise their demand for money either by holding it themselves or by placing it in the custody of a bank in a sight deposit or in a safe.

Fiscal stimulation and economic growth

Since government is not a wealth-generating entity, how can increased public spending revive the economy? Various people who will be employed by the government will expect compensation for their work. Note that the government can pay these individuals by taxing others who are still generating real wealth. In doing so, the government weakens the process of wealth creation and undermines the prospects for economic recovery. (We ignore borrowing from foreigners here).

From now on, fiscal stimulus could “work” if the flow of real savings increases to support, that is, finance, government activities while allowing a positive growth rate of the activities of the wealth generators. If, however, the flow of real savings declines, then no matter how much public spending increases, overall real economic activity cannot be revived. In this case, the more the government spends, that is, the more it takes from the generators of wealth, the more it weakens the prospects for recovery.

So when the government, through taxes, diverts bread to its own business, the baker will have less bread at his disposal. Therefore, the baker will not be able to obtain the services of the oven manufacturer. As a result, it will not be possible to increase the production of bread, all other things being equal.

As the pace of public spending increases, a situation might arise where the baker does not have enough bread to even maintain the operating capacity of the existing oven. (The baker does not have enough bread to pay for the services of a technician to maintain the existing oven). Therefore, his bread production will actually decrease.

Likewise, due to the increase in public spending, the other generators of wealth will have less real financing. This in turn will hamper the production of their goods and services and in turn delay and not promote overall real economic growth. In this scenario, the increase in public spending leads to a weakening of the wealth creation process in general.

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