Wednesday, November 19, 2008

Explaining "Stimulus Package" to Students

The government is considering another stimulus package to avoid a prolonged recession. I believe that most people believe that when the government gives consumers a rebate to increase spending, people view that rebate as "new" spending.

Yet, ask your students where the money for that rebate check comes from. The check is paid for, of course, by taxpayers. So in a sense, taxpayers are writing themselves a check. How does writing yourself a check for $100 increase spending? You receive $100, but you pay $100. Its not like you now have more money.

The answer has to do with money demand. For the stimulus package to work, the rebate must cause some people to hold onto less money than they would have held without the rebate check. If it works, it works as follows. I am the government and I pay you $100 in a rebate check, and you go out and spend that money on beer and goldfish crackers. To get the money I don't raise your taxes by $100, as that would negate the impact of the crackers. Instead, I borrow the money.

Out in the economy are some people who are savers and have a certain amount of money they are holding onto. To borrow this extra money, I must convince these people to save more, and I do so by offering a higher interest rate. So these people now hold onto less money, because the opportunity cost of holding onto the money (i.e. the interest rate) is now higher. Thus, I induced people who were holding onto money to hold onto less through the higher interest rate. Those savers give up some of the money they were holding, and pass it to you indirectly. You then spent that money and saved the economy.

Thus, if you get a rebate check for $100, not all of that $100 is new spending. Some of it would have been spent by the person the government borrowed the $100 from.

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