Saturday, October 01, 2011

Discretionary Fiscal Policy and Automatic Stabilizers

CFA Level 1 - Macroeconomics

Discretionary Fiscal Policy

Discretionary fiscal policy is made more difficult due to lags in recognizing the need for changed fiscal policy and the lags that occur with enacting the changed fiscal policy. Implementing the modified fiscal policy usually requires legislative action, which takes a long time to implement. There is a concern that fiscal policy changes may be ill-timed, however. For example, an expansionary fiscal policy may be enacted when the economy is already recovering from a recession. Fiscal policy does have an advantage over monetary policy in the sense that increased government spending leads to an immediate increase in aggregate demand. The effects of a tax cut may be more moderate and have more of a time lag because individuals may not immediately spend their increases in disposable income that resulted from the tax cut.
Ideally, fiscal policy will be used to increase aggregate demand during recessions and to restrain aggregate demand during boom times. Poorly timed fiscal policy could actually increase inflation and accelerate declines in the economy when the economy has already started to slow down.
One difficulty with proper timing is that forecasting economic activity is not an exact science. There is usually a lag between the time fiscal policy changes are needed and the instance that the need to act is widely recognized. There can also be a substantial amount of time between the time of recognition and the time that fiscal policy changes are actually enacted. Lastly, another difficulty with achieving proper timing is that the impact of a change in fiscal policy may not be felt until six to twelve months after the change has occurred.

Automatic Stabilizers

Automatic stabilizers,
without specific new legislation, increase (decrease) budget deficits during times of recessions (booms). They enact countercyclical policy without the lags associated with legislative policy changes. Examples include:
·Corporate Profits

- Taxes on corporate profits go up substantially during boom times, and decline rapidly during times of recession.
·Progressive Income Taxes

- Progressive taxation push people into higher income tax brackets during boom times, substantially increasing their tax bill and reducing government budget deficits (or increasing government surpluses). During recessions, many individuals fall into lower tax brackets or have no income tax liability. This increases the size of the government budget deficit (or reduces the surplus).

· The Unemployment Insurance (UI) Program

- This program provides payments to greater numbers of people as unemployment increases during times of recession. At the same time, the taxes that contribute to UI will go down as employment decreases. These two effects will cause the government budget deficit to increase. During boom times, the program will automatically produce surpluses (or reduce deficits) as fewer benefits are paid due to lower unemployment and tax revenues increase due to greater employment.
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