Question

8. Did the fiscal stimulus packages enacted following the financial crisis result in crowding out? Explain why or why not. (5 points)

Answer 1

The recent financial crisis and recession prompted unconventional and aggressive actions by monetary and fiscal policymakers. Monetary policymakers turned to quantitative easing. Fiscal policymakers increased government spending and reduced taxes. To better understand these widely debated actions, it is helpful to know the underlying intent of the decisions and the separate functions of monetary and fiscal policy.

Monetary policy, the responsibility of the Federal Reserve, is enacted through changes in the money supply and the federal funds rate (the rate at which banks lend money among themselves overnight). In theory, changes in the federal funds rate influence other market interest rates (e.g., mortgage, auto loan, and corporate bond rates). Changes in interest rates, in turn, affect saving and investment decisions.

Fiscal policy, the responsibility of Congress and the White House, is enacted through changes in government spending and taxes. During economic slowdowns, fiscal policy is often expansionary: The government increases expenditures and/or reduces taxes to increase total spending and encourage firms to increase production and hire more workers.

To stimulate the economy, in early 2009, Congress passed the $787 billion American Recovery and Reinvestment Act, a temporary stimulus that included $288 billion in tax cuts and benefits and more than $150 billion for sectors such as education, energy, and transportation. The fiscal stimulus package and the deep recession increased the government budget deficit.  Some economists believe such expenditures may contribute to future economic development. Others, however, argue that such expenditures lead to higher future taxes, which deters business investment today. This leads to the crowding out effect.