Question

On September 29, 2008, Congress failed to pass a spending bill that would have provided a fiscal stimulus in the face of panic in financial markets. Why did stock market values fall in response to this news? As part of your answer, explain what a fiscal stimulus is intended to do in terms of an aggregate supply/aggregate demand diagram. Be specific about which curve would shift and in which direction. What would happen to the overall price level and unemployment?

Answer 1

Amidst the financial crisis of 2008-09, the Congress failed to pass a spending bill, which translated into a stock market decline. To elaborate on the reason, the first point to note is that when the economy is in a slowdown or recession, the government pursues expansionary fiscal policy. This includes reduction in tax rate and/or increase in government spending.

The objective of the fiscal stimulus is to increase aggregate demand. In other words, shift the aggregate demand curve to the right that would represent higher output and higher price levels (higher inflation) in the economy.

Just as an example, if the government reduces taxes, consumer disposable income increases. This triggers higher consumption spending in the economy, which also boosts investment spending. Therefore, as consumption and investment increase on a relative basis, the aggregate demand curve shifts to the right. At the same time, relatively higher investment spending creates jobs (reduces unemployment ) in the economy.

Further, when the stimulus package it intended to increase government spending, it also has a positive impact on aggregate demand and shifts the curve to the right. Price levels in the economy increase and jobs are created. Just as an example, when the government increases infrastructure spending, it creates jobs and boosts industries related to infrastructure. Similarly, if the government increases defense spending, it triggers growth for defense sector companies.

Therefore, the failure to pass the spending bill implied that government spending in the economy will not increase and therefore the stock markets reacted negatively. Had government spending increased and triggered higher growth, the stock markets would have reacted positively.