Fiscal Stimulus vs. Economic Growth

by Frank Shostak

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.

[…] 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.

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