Discretionary Fiscal Policy
1. Expansionary vs. Contractionary Policy
Discretionary fiscal policy has two main approaches depending on the economic situation. When the economy is weak and unemployment is high, the government uses expansionary policy. This means increasing spending (like building roads) or cutting taxes to put more money in people's pockets, boosting demand. When the economy is growing too fast and prices are rising (inflation), it uses contractionary policy—cutting spending or raising taxes to cool things down.
| Policy Type | Government Action | Goal | Example |
|---|---|---|---|
| Expansionary | ↑ Spending / ↓ Taxes | Fight recession, lower unemployment | Building a new high-speed rail |
| Contractionary | ↓ Spending / ↑ Taxes | Control inflation, slow down economy | Reducing the budget for military bases |
2. The Multiplier Effect in Action
A key idea behind discretionary policy is the multiplier effect. An initial change in spending or taxes can lead to a larger change in national income. For example, if the government spends $1 billion on building a bridge, the construction workers earn wages and spend that money at local stores. Those store owners then hire more staff or order more goods, creating another round of spending. The total impact is a multiple of the original $1 billion. The simple formula is:
Where the simple multiplier = $1 / (1 - MPC)$ and MPC is the marginal propensity to consume.
3. Real-World Examples: Fighting Recessions
A classic example of expansionary discretionary policy was the American Recovery and Reinvestment Act of 2009. During the Great Recession, the U.S. government passed a law to increase spending on infrastructure, extend unemployment benefits, and send tax rebates to families. The deliberate goal was to create jobs and boost consumer spending to pull the economy out of a deep downturn. This shows how governments use their power to tax and spend to actively manage economic health.
Important Questions About Fiscal Policy
A: Discretionary policy requires new laws to be passed by the government (like a new stimulus bill). Automatic fiscal policy[1] happens without any new action, like unemployment benefits rising automatically when people lose their jobs.
A: There are two main delays. First, it takes time for the government to recognize there is a problem (recognition lag). Second, it takes time for politicians to debate and pass a bill (implementation lag). By the time the policy is enacted, the economy might have already changed.
A: Yes, by leaving more money in the hands of consumers and businesses. For example, if the government cuts the income tax rate, families have more take-home pay to spend on goods and services. This increased demand encourages companies to hire more workers, helping to reduce unemployment.
Footnote
[1] Automatic stabilizers: Government programs that automatically help stabilize the economy without new legislation. Examples include the progressive income tax system (you pay less tax when you earn less) and unemployment insurance.