Question

The economy is in a recession, and the recessionary gap is large. a. Describe the discretionary and automatic fiscal policy actions that might occur. b. Describe a discretionary fiscal stimulus package that could be used that would not bring an increase in the budget deficit. c. Explain the risks of discretionary fiscal policy in this situation.

Short answer

Discretionary fiscal policies include increasing public spending and cutting taxes, while automatic policies involve unemployment benefits. A budget-neutral stimulus reuses existing funds. Risks include timing delays, political disagreements, and potential inflation.

Step-by-step solution

Understanding Fiscal Policies

Fiscal policy involves government adjustments to its spending and tax rates to influence a nation's economy. Discretionary fiscal policy is a deliberate action by the government, like changing tax rates or altering government spending. Automatic fiscal policy, also called automatic stabilizers, are policies that automatically adjust without government intervention, such as unemployment benefits.

Discretionary and Automatic Fiscal Policy Actions

To address the recessionary gap, the government might implement discretionary fiscal policy actions such as increasing public spending on infrastructure projects or cutting taxes to stimulate demand. Automatic fiscal policies would trigger more unemployment benefits and welfare payments as more people become eligible, which would naturally increase disposable income and consumption.

Designing a Fiscal Stimulus Package Without Increasing the Budget Deficit

A discretionary fiscal stimulus package that does not increase the budget deficit can be designed by reallocating existing government resources. This could include diverting funds from less critical projects to more urgent and impactful ones like infrastructure and education. Additionally, implementing efficiency measures to reduce unnecessary government spending can free up funds for economic stimulus.

Risks of Discretionary Fiscal Policy

Discretionary fiscal policy can face timing problems—delays in recognition, decision, and implementation can reduce its effectiveness. There is also political risk, as differing political agendas can stall or alter fiscal policy measures. Furthermore, if the stimulative measures are too aggressive, they might lead to inflationary pressures.

Key concepts

Discretionary Fiscal Policy

Discretionary fiscal policy refers to intentional actions taken by a government to influence economic activity. These actions usually involve changes in government spending or tax policies.
For instance, in times of recession, the government might decide to increase spending on infrastructure projects, such as building roads and schools. This can create jobs and stimulate economic growth.
Alternatively, the government might choose to cut taxes. Reducing taxes puts more money in people's pockets, which can encourage them to spend more, thus boosting demand.
Discretionary measures are usually short-term and specific to the economic challenges at hand. They require active decision-making by policymakers and are not automatic.
While these policies can be powerful, they also have drawbacks, such as potential delays in implementation and political disagreements that can hinder timely action.

Automatic Stabilizers

Automatic stabilizers are fiscal mechanisms that kick in without any new government action. They help to soften the blow of economic fluctuations automatically.
Examples include unemployment benefits and progressive income taxes. During a recession, more people become unemployed and are eligible for unemployment benefits, which provides them with income to spend and helps maintain demand for goods and services.
Similarly, progressive income taxes mean that as people earn less, they pay less in taxes, which also helps to cushion their disposable income during economic downturns.
The advantage of automatic stabilizers is that they are fast and do not suffer from the same delays or political hurdles as discretionary fiscal policies.

Budget Deficit

A budget deficit occurs when the government spends more money than it receives in revenue over a particular period, typically a fiscal year.
In the context of a fiscal stimulus package, increasing spending or cutting taxes without a corresponding increase in revenue can enlarge the budget deficit.
A larger budget deficit may lead to higher national debt, which can be a concern for future economic stability.
Managing a budget deficit requires careful balancing. While deficit spending can be necessary to pull an economy out of a recession, it is essential to consider long-term fiscal health.

Fiscal Stimulus Package

A fiscal stimulus package is a set of government measures designed to boost economic activity. This can include increased public spending, tax cuts, or a combination of both.
To avoid increasing the budget deficit, the government can reallocate funds from less critical areas or eliminate inefficient spending.
For example, shifting funds from administrative overhead to direct public services like healthcare or education can still stimulate the economy without increasing the total expenditure.
Another approach is to improve tax collection efficiency, thereby increasing revenue without raising taxes.

Economic Risks

Implementing discretionary fiscal policy comes with its own set of risks. One such risk is the timing lag, which includes recognition lag, decision lag, and implementation lag. Delays in recognizing economic issues, deciding on the appropriate action, and putting that action into place can reduce the effectiveness of the policy.
There is also a political risk because political disagreements can stall or alter the measures, making them less effective or even counterproductive.
Moreover, over-stimulating the economy can lead to inflation, where prices of goods and services rise too quickly, damaging purchasing power.
Therefore, while fiscal policies are essential tools, they need to be carefully designed and executed to minimize these economic risks.