What is a stimulus

At the request of fellow commenter Robert D. Feinman, I’m expanding a comment from Economist’s View into a full blog post. Apropos of Paul Krugman’s column on the fiscal stimulus plan, Robert posted a comment asking:

What is "savings"? I understanding taking the check over to Walmart.

If I take the check and deposit it in my local bank what then? The bank loans out the money or buys notes from the Treasury (lending to the government). The money is then spent by the recipient. The difference is that in one case I determine how the money is "spent", in the other I delegate the spending to some one else. Why is one a stimulus and the other not?

In a later comment, I answered:

When you deposit the money in the bank, it doesn't actually get loaned out; it gets withdrawn by the Fed. That's an oversimplification, but it's roughly what happens. If you deposit money in the bank, it makes more money available in the banking system, which tends to push down the federal funds rate; but the Fed has a policy of controlling the federal funds rate, so it will act to offset your deposit by selling treasury bills (or, more precisely, probably, by buying fewer treasury bills than it otherwise would).

This raises the question of why we would need a fiscal stimulus in the first place, because if it wanted to, the Fed could just put more money in the banking system (causing the federal funds rate to fall), and there would be more loans and more purchases and we'd get the same stimulus. And the reason has to be something bad about low interest rates, but it's not clear exactly what. Maybe we're worried that low interest rates would weaken the dollar too much and cause an import price shock. Or maybe we're worried that interest rates will go down to zero (as they did in Japan), in which case banks might be unwilling to lend out the money that the Fed creates (since they wouldn't be taking any loss by just holding it, and the risks of lending might be too high).

I could add here that I think both of these considerations are things we should be worrying about right now.

Now that I think about it, though, the reason doesn’t have to be something bad about low interest rates; it could be, for example, the lag in effectiveness: one may imagine that tax rebates will be spent (if they are spent at all) more or less immediately, whereas if the money is in the banking system, it takes time to lend out, and it takes time for the borrowers to spend it.

When I actually say it, that argument doesn't sound very convincing, so I'll go back to "something bad about low interest rates," but I'll note that the "something bad" may also relate to policy lags. For example, if the "something bad" is an excessive housing boom, that also has a delayed economic stimulus effect, so that's a reason that the Fed can't do as big an initial stimulus with monetary policy as the government could do with fiscal policy.