How does discretionary fiscal policy fight recession?

What’s it: Discretionary fiscal policy is a deliberate government policy to influence the economy by changing its spending and income. It is deliberate because the government intends to change items in its budget or revenue to direct the economy to the desired condition. The new budget will require approval or a vote before being implemented.

Budget changes affect aggregate demand, ultimately affecting economic growth, inflation, and unemployment rates. An increase in government spending has a direct impact on aggregate demand. Meanwhile, changes in taxes affect government revenues as well as private sector consumption and investment. These changes aim to spur or moderate economic growth as needed.

Keynesian economists argue about how important government intervention is to affect the economy. For example, the economy cannot rely on the private sector during a recession to recover. As rational economic actors, they will save more as their income and profits deteriorate during this period. And they will reduce consumption and investment. Thus, the economy is not strong enough to rely on them to stimulate growth.

In these conditions, the government takes an important role. The government deliberately aims its budget into a deficit by increasing its spending, lowering taxes, or combining the two options. An increase in government spending, such as infrastructure spending, increases aggregate demand. Building infrastructure creates jobs and income for households. And it also stimulates related businesses to increase activity.

Meanwhile, lower taxes mean households and businesses charge less. As a result, they have more dollars to spend or invest.

Thus, increasing spending and cutting taxes increases aggregate demand, prompting the economy to recover. Stronger aggregate demand will encourage the economy’s output to increase.

What is a discretionary fiscal policy and nondiscretionary fiscal policy?

The discretionary fiscal policy requires the government’s deliberate action to change its budget. The government needs to intervene to stabilize the economy and avoid negative effects such as a spike in inflation or a recession.

Budget changes require concrete action and approval before they are implemented. For example, the government should change the tax law when it raises the tax rate. Alternatively, the budget requires parliamentary approval before it becomes effective.

In contrast, nondiscretionary fiscal policy works automatically. Sometimes we call it an automatic stabilizer. Some items in government spending and income rise and fall with the cycle of the economy. However, they work counter-cyclically, where the effect is inversely related to the current cycle.

Take unemployment benefits as an example. Such spending will rise during a recession as the unemployment rate rises. But, on the contrary, it will decline during an economic expansion as the unemployment rate decreases and households are more prosperous.

Unlike discretionary policies, automatic stabilizers work without requiring deliberate government action. For example, it does not require the government to amend related laws and regulations or require parliamentary approval to take effect. However, discretionary policies may be taken when the government’s automatic stabilizers are not strong enough to stabilize the economy.

How does discretionary fiscal policy affect the economy?

Discretionary fiscal policy affects the economy through its effect on aggregate demand. Economists define aggregate demand as the sum of:

• Household consumption
• Business investment
• Government spending
• Net exports

An increase or decrease in aggregate demand affects the economy’s output and other economic indicators such as inflation and unemployment rates.

For example, the government increases its spending. This increase resulted in higher aggregate demand. And the price level begins to increase (upward inflation pressure).

Businesses respond to these price increases by raising production to reap more profits. They then hire labor or increase overtime to increase output, creating more income and jobs in the economy. As seeing better income and job prospects, households increase their consumption. Increased consumption makes aggregate demand grow higher.

Stronger demand pushes the price level up. And business again increases output. Moreover, they are likely to increase investment because production capacity has been maximized. They also recruited more workers.

As a result, increased government spending leads to higher economic growth due to stronger aggregate demand. Inflation rises. In addition, the unemployment rate also decreases.

Meanwhile, tax changes also affect aggregate demand, but not directly. Its increase or decrease impacts the dollars available for consumption and savings.

For example, the government introduces lower income tax rates. This decrease makes disposable income increase. Thus, more dollars are available to spend or save. And finally, it encourages households to spend more. As a result, consumption rises so does aggregate demand.

An increase in demand pushes the price level upwards. As seeing strong demand, businesses increase their output. They take steps to increase production, for example, by investing in capital goods and hiring more workers. As a result, lowering the tax rate increases economic growth, pushing inflation and lowering the unemployment rate.

The opposite effect occurs when the government lowers its spending or increases its tax rate. A decrease in spending reduces aggregate demand, as does an increase in taxes. As a result, economic growth slows, inflationary pressures decreases, and unemployment increases.

What is a discretionary fiscal policy example?

The discretionary fiscal policy requires the government to change the items in its budget. The two tools used are government spending and taxation. Such changes require special approval from the president and parliament or require changes to relevant laws and regulations.

For example, the government increases the infrastructure budget to build roads, bridges, and ports. This increase in the budget creates demand for goods and services in the economy, prompting increased economic activity.

Unlike spending on social security or unemployment benefits, the government deliberately plans the increase in infrastructure spending to have a multiplier effect on the economy. For example, it may require the government to introduce, amend or repeal relevant laws.

Taxation is the second tool. The government may use higher rates to moderate aggregate demand. Or, conversely, cutting tax rates to stimulate economic growth. Changes in taxation must be made by enacting new laws.

What is the purpose of discretionary fiscal policy?

Discretionary fiscal policy aims to stabilize the economy. It moderates the deviation in the output gap (see macroeconomic equilibrium). It works to stimulate economic growth during a recession and moderate the inflation rate and economic growth during expansion.

For example, in the final phase of expansion (called the economic boom), the economy may operate above its potential output (a positive output gap). As a result, inflation rises high, disrupting the economy’s stability. If not suppressed, inflation can soar much higher. High inflation overheats the economy and can lead to hyperinflation, which is dangerous because the purchasing power of money falls in an instant.

On the other hand, during a recession, the government struggles to recover the economy. An increase in government spending and a decrease in taxes can be a recipe for stimulating economic growth. During this period, the private sector was not strong enough to pull the economy out of recession.

What are the types of discretionary fiscal policy?

There are two discretionary fiscal policies based on the objectives. They are:

1. Expansionary policy
2. Contractionary policies

Both aim to stabilize the economy and use the same tools. However, both have the opposite effect on aggregate demand. Expansionary policies aim to increase aggregate demand and therefore stimulate economic growth. Conversely, contractionary policies aim to moderate aggregate demand and inflationary pressures; therefore, weaker economic growth is a consequence.

Expansionary policy

Expansionary fiscal policy works to stimulate economic growth. The government adopts it when the economy is weak or in recession. Sometimes we call it loose fiscal policy.

The government takes the following options to spur economic activity:

• Cut taxes
• Increase discretionary spending

The government may choose to combine the two if necessary. Cutting taxes and increasing discretionary spending usually lead to a budget deficit. Lower taxes mean less income. On the other hand, the government should spend more to stimulate economic growth.

Increased government spending creates more demand for goods and services in the economy. The situation finally stimulates businesses to increase their output. Among the increased spending items are spending on infrastructure and public works.

Building infrastructure creates jobs directly. The effect can also occur indirectly. Demand for construction-related goods and services increases, prompting businesses to hire more workers to meet the increased demand. Ultimately, it creates income for businesses and households. Thus, government spending contributes to giving people more money to spend, increasing demand.

Meanwhile, more money is available to spend or invest when the government cuts taxes. Households pay lower tax bills, leaving them with more dollars to spend. Likewise, businesses have more profit to reinvest into the business because they pay lower taxes.

Increases in demand and investment eventually push aggregate demand up. The price level follows due to stronger demand. Businesses increase production with strong demand and higher prices to reap more profits. They recruit more workers, lowering the unemployment rate. Households expect their incomes and jobs to improve, prompting them to increase demand further.

As a result, expansionary policies lead to higher economic growth. In addition, the inflation rate also crawled up due to strong demand. Another effect is the declining unemployment rate.

Contractionary policies

Contractionary fiscal policy works and has the opposite effect as expansionary policy. We call this a tight fiscal policy.

The government adopts economic policies during the final phase of expansion. As a result, the economy tests the upper bound, and an expansionary gap occurs, in which the economy operates above its productive capacity (real GDP exceeds potential GDP). During this period, inflationary pressures are high, overheating the economy. If not addressed, inflation can spike uncontrollably and can lead to hyperinflation.

The surge in inflation jeopardizes economic stability. This situation forces the government to intervene. The government then increases taxes and reduces spending to moderate aggregate demand.

Raising taxes increases households’ and businesses’ bills. That leaves them with fewer dollars available for shopping and investing. As a result, aggregate demand decreases.

Weaker demand moderates price pressures, easing inflationary pressures. In addition, it encourages businesses to reduce expansion. As a result, output grows more slowly, as does economic growth. They also stop to recruit new workers and tried to maximize the existing workforce.

Long story short, expansionary policies not only reduce inflationary pressures. But, it also lowers economic growth and stops the unemployment rate from falling further.

However, if fiscal tightening is carried out aggressively, it could create problems. That could lead to an economic contraction in which aggregate output falls. The price level may fall and cause deflation. Then, the unemployment rate could rise as businesses cut their production and take efficiency measures.

What to read next

• Automatic Stabilizer: Meaning, Types, How It Works
• Autonomous Expenditure: Formula, Components, Determinants
• Balanced Budget: Why It Matters, The Multiplier Effect
• Budget Deficit: Formulas, Causes, and Effects
• Budget Surplus: Why It Occurs and Its Effects
• Cyclical Budget Deficit: Causes, How it Works, Impacts
• Discretionary Fiscal Policy: How it Works, Types, Effects
• Government Budget: Components, Types, and Fiscal Policy
• Government Capital Expenditures: Examples, Why It Matters
• Government Current Expenditure: Example, Calculation in GDP
• Government Discretionary Spending: What Is It? What are some examples?
• Government Expenditure: Components and Effects on the Economy
• Government Revenue: Types and Why Does It Matter?
• Induced Expenditure: Examples, Formula
• Induced Tax: Examples, How they Work, Effects on the Economy
• National Debt: What is it and What Are the Implications?
• Net Tax in Macroeconomics: Formula, Effects on the Economy
• Structural Budget Deficit: How it Works and Its Implications
• Tax: Types and Its Impact on the Economy
• Transfer Payments: Importance, Types, and Criticism