Discretionary Fiscal Policy
What is Discretionary Fiscal Policy?
Discretionary fiscal policy is deliberate changes in government spending or taxes enacted by legislation to influence the economy.
Unlike automatic stabilizers, it requires active decisions by lawmakers, such as a stimulus package or tax rebate. It is subject to recognition, decision, and implementation lags. Infrastructure bills and one-time tax rebates are examples.
Discretionary Fiscal Policy: a worked example
An economy sits $300 billion below potential output and the MPC is 0.8. Lawmakers weigh two discretionary options. Direct purchases use the spending multiplier 1 ÷ (1 − 0.8) = 5, so $300 billion ÷ 5 = $60 billion of new government purchases closes the gap. A rebate uses the tax multiplier 0.8 ÷ 0.2 = 4, so the rebate must be $300 billion ÷ 4 = $75 billion, or $15 billion more for the same result. Then come the lags that define discretionary policy. Data confirm the downturn two quarters after it begins, the bill takes three more quarters to pass, and the money reaches contractors two quarters after that. Seven quarters elapse before the first dollar is spent, by which point the gap may have closed without help.
The mistake students make with discretionary fiscal policy
Automatic stabilizers get filed under discretionary policy. Unemployment benefits rising in a downturn and income tax receipts falling both move G and T in the stabilizing direction, so they look like the same tool. The test is whether a new vote was required. Discretionary means lawmakers passed something new, such as a rebate check or an infrastructure bill. Stabilizers operate under laws already on the books, respond instantly, and need no legislature, which is exactly why they escape the lags that hobble discretionary action.
Discretionary Fiscal Policy questions
Can discretionary fiscal policy be contractionary?
Contractionary discretionary policy cuts government purchases or raises taxes to pull aggregate demand back when real GDP sits above potential and prices are climbing quickly. The vote requirement is identical, only the direction changes. Legislatures reach for it less often than the expansionary version, because cutting programs and raising taxes carries a political price, so tightening during a boom is usually left to the central bank.
Why do lags weaken discretionary fiscal policy?
Three lags stack up. The recognition lag is the time before data reveal the downturn, the decision lag covers debate and passage, and the implementation lag is the delay before money is actually spent. If those add to six or seven quarters, the stimulus can land after the recovery has already begun, pushing an economy that is growing again and adding to inflationary pressure instead of filling a gap.
Is a one-time tax rebate discretionary fiscal policy?
A one-time rebate passed by the legislature counts as discretionary fiscal policy, because the change came from a deliberate vote rather than from rules already on the books. Its size can be chosen to target a specific output gap. Households save part of any rebate, though, so the rebate has to be larger than an equivalent increase in purchases to move aggregate demand by the same amount.
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Related terms
Common comparisons
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