What is a stimulus package?

Stimulus package is a term used to represent a variety of government spending programmes and taxation measures used to stabilise the economy or encourage growth in a particular industry. Generally, government economic stimulus is used to recover from a period of economic stagnation or recession by encouraging spending and investment and as a result, employment.

Types of stimulus package

What is included in the stimulus package? The exact content can be tailored to target specific sectors of the economy which are most impacted by the downturn. There are three main methods for a government to encourage spending within the economy. These are expansionary monetary policy, fiscal policy and quantitative easing.

• Monetary policy

Prime interest rates are set by a country's central bank as a method of regulating inflation. During economic downturns the central bank can reduce interest rates to encourage borrowing by making it less expensive. Increased borrowing increases the total money supply and should result in higher levels of spending. Lower interest rates can also have the effect of lowering the exchange rate, making a country's exports more attractive and stimulating economic growth.

• Fiscal policy

Fiscal policy encompasses government tax policies as well as government spending. It is separate from monetary policy as it is part of government policy and not controlled by the central bank. Expansionary fiscal policy as a component of a stimulus package means an increase in government spending and/or a reduction in taxation. Spending and tax decreases can be targeted to specific industries or citizens, such as low income earners.  

• Quantitative easing

Similar to monetary policy, quantitative easing (QE) is an economic policy administered by a central bank. QE involves the central bank purchasing large volumes of financial assets such as government bonds. These purchases have the effect of increasing the supply of money available in the economy, which encourages capital investment and spending. Another outcome of these large purchases, specifically in the case of government bonds, is a decrease in the expected return on such investments. Decreased yields on bonds in turn makes other investments like stocks or real estate seem more attractive to investors, further stimulating economic activity. 

Impact of stimulus package: Potential risks

The effectiveness of stimulus packages comes hand in hand with inflation risks. Basic economic theory states that if a country increases the supply of money through monetary expansion, the value of its currency will decrease as a result of increasing inflationary pressure. Inflation is a real concern when the economic stimulus programme is in place, and many governments tend to reduce spending as soon as the economy has stabilised.

The purpose of the stimulus package is to encourage growth and many countries are forced to increase their foreign debt levels in order to fund various schemes with the intention of recovering these costs later. Small or unstable countries run the risk of not being able to service these larger debt burdens over time, which can result in rampant inflation and potential currency depreciation over the long term.