Crisis Management: Stimulation of Domestic Demand

In stimulating domestic demand, Asian countries have lowered interest rates and improved the availability of credit, but these measures have proved to be of limited effectiveness for economies in a liquidity trap.¹ This perception of ineffectiveness has driven policymakers to rely more on fiscal measures, such as cutting taxes and increasing spending on public works projects, as the prime instruments of the stimulus. The PRC, Japan, Republic of Korea, and Malaysia have all implemented large fiscal stimulus packages, but there are indications that these expansionary macroeconomic policies may not be sufficient and that they will have to be fortified further to ensure that Asian economies do not fall deeper into recession if the recovery of the American economy stagnates.

In managing fiscal policy, the authorities will first need to estimate the magnitude of multipliers of government spending and tax cuts, which, according to recent studies (IMF 2008; Barro and Redlick 2009), tend to be small, and then use these estimates to formulate a variety of public expenditure programs and tax reductions to enhance stimulus packages with a minimum of administrative lag. At the same time, public spending programs will need to be chosen not only for their short-term expansionary effect, but also in terms of their ability to contribute to long-term improvements in total factor productivity. Even if the countercyclical effects are strong, fiscal stimulus could be counterproductive in the long run as it could raise the real interest rate, mask structural weakness, and postpone much needed structural reforms. Furthermore, in the short run, Asian policymakers are well aware that, for their export-oriented economies, there is a limit to the extent to which expansionary monetary and fiscal policy can fill the void created by the decline in external demand.

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