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Fiscal Stimulus: The Wrong Economic Remedy

By Byron A. Ellis

March 05, 2008

The fiscal stimulus of approximately $150 billion supported by the Administration, Congress, and the Chairman of the Federal Reserve should, overtime, increase GDP, as well as inflation, interest rate, and unemployment.

Large government transfers increase government expenditures. Government expenditure is a component of gross domestic product (GDP). Business investment, consumer and government spending determine GDP (Y = C + I + G). The largest component of GDP is private consumer spending. David Adolffato notes that private consumer spending in the United States is between 50 and 60% of GDP, private investment about 20 to 30% of GDP, and government spending about 20 to 25% of GDP.

If the propensity to consume out of disposable income, after tax income, is 90% and the income tax rate is 20%, then, over time, GDP due to the stimulus would increase by about $500 billion, as a result of the multiplier effect.

However, the rise in the cost of crude oil is akin to a war tax on consumers, a tax that accrues to energy suppliers. Thus, the rise in crude oil prices will act as a tax increase on consumers, leading to a smaller multiplier. A smaller multiplier reduces the increase in GDP to about $400 billion. Furthermore, if we account for inflation, the real increase in GDP will be less than $400 billion.

The multiplier indicates by how much we have to multiply a given change in government transfer to obtain the change in equilibrium income and aggregate demand.

On the revenue side, the government has the potential to collect, over time, about $100 billion in taxes from the stimulus, leaving a net deficit of approximately $50 billion.

The Federal Reserve (Fed), on the other hand, will be forced to raise interest rates to combat inflation from rising crude oil prices and the stimulus.

As the Fed increases interest rate, the economy will slow down, unemployment will increase, and government revenue will decrease.

Thus, in the face of war induced crude oil prices, fiscal stimulus and unchecked monetary expansion are likely to cause swings in GDP growth rate.

The main problem with the economy is increasing crude oil prices. Crude oil is the lifeblood of our current transportation system. Therefore, it adversely affects commodities and services that relies on conventional transportation systems, as well as the disposable income of employees that use vehicles to get to work.

Clearly, increasing government spending will, in the short run, increase GDP, but it will not reduce the price of crude oil. So the remedy embraced by the Administration, Congress, and the Federal Reserve is a mirage.

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