Subject 8. Active and Discretionary Fiscal Policy

Fiscal policy actions seek to stabilize the business cycle by changing aggregate demand. These policy actions can be:

  • Discretionary. Discretionary fiscal policy is a policy action that is initiated explicitly by the government.
  • Automatic. Automatic fiscal policy is a change in fiscal policy triggered by the state of the economy.

To reduce economic disturbances, fiscal policy must be put into effect at the proper time in the business cycle. Policy changes take time; thus, when they take effect, the recession or inflationary overheating may have passed. For example, during an economic downturn, a government uses expansionary fiscal policy to stimulate aggregate demand. Suppose, by the time the expansionary fiscal policy starts to exert its primary impact, the economy's self-corrective mechanism has restored full employment capacity. Therefore, the stimulus injected by expansionary fiscal policy will result in excessive demand and inflation, causing more economic instability.

The use of discretionary fiscal policy is hampered by three time lags:

  • Recognition lag. There is usually a time lag between when a change in policy is needed and when its need is widely recognized by policymakers. Forecasting a forthcoming recession or boom is a highly imperfect science.
  • Action lag. There is generally a lag between the time when the need for a fiscal policy change is recognized and the time when it is actually instituted. The time required to change tax laws and government expenditure programs is quite lengthy.
  • Impact lag. Even after a policy is adopted, it may be 6 to 12 months before its major impact is felt.

Changes in fiscal policy must be timed properly if they are going to exert a stabilizing influence on an economy. However, the use of fiscal policy to calm the business cycle is very difficult; it may accentuate the corrective action of the economy rather than correct the problem for which it was intended. In the real world, a discretionary change in fiscal policy is like a double-edged sword - it has the potential to do harm as well as good. If timed correctly, it will reduce economic instability. If timed incorrectly, however, the fiscal change will increase rather than reduce economic instability.

Automatic Stabilizers

Automatic stabilizers apply stimulus during a recession and restraint during a boom even though no legislative action has been taken. Their major advantage is that they institute counter-cyclical fiscal policy without the delays associated with policy changes that require legislative action. During a recession, they trigger government spending without the authorization of Congress (unemployment compensation and welfare programs). During inflationary overheating, they take spending power out of the economy without the delays caused by legislative actions, thereby minimizing the problem of proper timing.

Income taxes and transfer payments are automatic stabilizers.

When the economy starts to fall into a recession, unemployment increases. Government payments for unemployment compensation will increase while government receipts from the employment tax that finances unemployment benefits will decline. As a result, the unemployment compensation program automatically promotes a budget deficit. Similarly, when the economy expands into an inflationary boom, the program promotes a budget surplus.

When the economy expands into an inflationary boom, personal income will grow sharply. As a result, more people will fall into the "tax due" category, and others will be pushed into higher tax brackets. Therefore, income tax revenues will rise more rapidly than income, reducing the momentum of consumption growth. In addition, higher tax revenues will promote a budget surplus.

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maryprz14: I actually enjoyed reading this. Common sense.
IatLs: AN has a number of references to the US gov't, banks, etc. I am reading Congress and thinking, 'what is that?' Only on further reflection do I realize that is a reference to the US parliament. AN, kindly keep non-US students in mind... the program is tough enough without having to crack american code. Bless you.