Question

The economy is in a boom and the inflationary gap is large. a. Describe the discretionary and automatic fiscal policy actions that might occur. b. Describe a discretionary fiscal restraint package that could be used that would not produce serious negative supply-side effects. c. Explain the risks of discretionary fiscal policy in this situation.

Short answer

Discretionary actions: reducing spending, increasing taxes. Automatic actions: progressive taxes, reduced benefits. Risks: timing issues, political resistance, and overcorrection.

Step-by-step solution

Define Discretionary Fiscal Policy and Automatic Stabilizers

Discretionary fiscal policy involves deliberate changes in government spending or taxation to influence the economy. Automatic stabilizers, on the other hand, are built-in fiscal mechanisms that automatically adjust taxes and spending in response to economic changes without the need for active intervention.

Identify Discretionary Fiscal Actions

In a scenario of a large inflationary gap, discretionary fiscal policy actions could include reducing government spending and/or increasing taxes. These actions are taken to reduce aggregate demand and curb inflation.

Identify Automatic Fiscal Policy Actions

Automatic stabilizers in this context might include progressive income taxes and unemployment benefits. As incomes rise during a boom, people move into higher tax brackets, leading to increased tax revenue and reduced disposable income, which helps to moderate economic expansion.

Design a Fiscal Restraint Package

A discretionary fiscal restraint package might include measures such as reducing government subsidies or increasing direct taxes on higher income groups. These measures should be designed to minimize negative effects on productivity and investment. For instance, temporary surtaxes or targeted spending cuts may be used rather than broad-based spending reductions.

Assess Risks of Discretionary Fiscal Policy

Discretionary fiscal policy in such a situation carries the risk of timing issues, including delayed implementation and impact. There's also a risk of political resistance and unforeseen side effects on economic activity. Moreover, potential overcorrection could lead to a recession by overly suppressing demand.

Summarize the Risks

The primary risks include timing delays, political obstacles, and overcorrection of the economy. Ensuring that fiscal actions are timely and appropriately scaled is crucial to avoid triggering a recession.

Key concepts

Automatic Stabilizers

Automatic stabilizers are built-in economic policies that work without any new government intervention. They help keep the economy steady, especially during booms and busts.
For example:

• Progressive income taxes: As people earn more, they pay a higher percentage in taxes.
• Unemployment benefits: When people lose jobs, they receive benefits that keep their spending stable.
• Welfare benefits: Programs like these increase without any new laws during hard times.

These automatic stabilizers are crucial because they help smooth out the ups and downs of the economy. They increase during bad times to support demand and withdraw during booms to prevent overheating.

Inflationary Gap

An inflationary gap occurs when the actual output of an economy exceeds its potential output. This situation usually happens during a boom when demand is very high.
In simple terms, there’s too much money chasing too few goods.
Here are some consequences of an inflationary gap:

• Prices rise, leading to inflation.
• Businesses struggle to keep up with demand.
• Interest rates might increase as authorities try to cool down the economy.

To close an inflationary gap, governments often use fiscal policies to reduce spending or increase taxes, thereby reducing overall demand.

Fiscal Restraint Package

A fiscal restraint package involves measures the government takes to slow down an overheating economy without causing too much harm.
Components of a fiscal restraint package might include:

• Reducing government spending: Cutting back on subsidies or public projects.
• Increasing taxes: Raising taxes on higher income groups to decrease disposable income.
• Temporary surtaxes: Temporary taxes that can be quickly introduced and removed.

The goal is to find a balance. The government wants to cool the economy but avoid triggering a recession or high unemployment. Careful design of these measures is crucial to minimize negative side effects, like harming investment or productivity.

Timing Issues

Timing is everything in fiscal policy. When the government decides to intervene, several timing issues can arise:

• Implementation delay: It takes time to pass laws and changes through political processes.
• Impact delay: Even after a policy is implemented, it takes time for the effects to be felt in the economy.
• Political resistance: Different political interests can slow down or change the policy’s course.

Mismatched timing can worsen the situation. For example, delayed actions might overcorrect the economy when it has already started to stabilize, risking a recession.
Effective fiscal policy requires careful planning and quick implementation to match the economy's changing conditions accurately.