Discretionary Fiscal Policy

Discretionary fiscal policy represents changes in government spending and taxation that need specific approval from Congress and the President. Examples include increases in spending on roads, bridges, stadiums, and other public works. Because discretionary fiscal policy is subject to the lags discussed in the last section, its effectiveness is often criticized. Automatic stabilizers, on the other hand, do not need government approval and take effect immediately.


Automatic Stabilizers

Automatic stabilizers are changes in government spending and taxation that do not need approval by Congress or the President. Automatic stabilizers are expense and taxation items that are part of existing economic programs.

Examples of automatic stabilizers include

1. Unemployment compensation.
When the economy turns down, the government’s expense on unemployment compensation automatically increases as more people lose their jobs. According to Keynesians, this increase in government spending prevents the economy from a more severe slowdown compared to what would occur if no unemployment compensation existed.

2. Subsidies to farmers.
When the economy turns down and farmers struggle, the government’s expenses on farmer subsidies automatically increase. According to Keynesians, this increase in government spending stimulates the economy.

3. A progressive tax system.
Most industrialized countries’ tax systems are set up to tax higher-income individuals and corporations at higher rates. If the economy slows down, incomes decrease, and people pay less money in taxes. This decrease in tax (compared to a system without progressive taxes) puts more money in people’s pockets and stimulates private spending.

Active Government Policy and Crowding Out

Keynes strongly supported automatic stabilizers. The advantage of automatic stabilizers is that they do not suffer from the three lags mentioned in the previous section. Some economists, however, still question the effectiveness of automatic stabilizers, or any active fiscal policy, for that matter. Anytime government spending increases, the funds have to come from somewhere. Government borrowing during recessionary gaps typically increases. Increased borrowing leads to something economists call crowding out. Crowding out is when government borrowing “crowds out” (replaces) funds that otherwise could be used by the private sector. The more the government borrows from the private sector, the fewer funds are available in the private sector for investments, research and development, etc. 

Keynesians suggest that instead of borrowing the money, the government can increase its money supply and, thus, generate funds for the additional spending. However, classical economists believe that increasing the money supply equates to inflation. According to the classical school, either method (borrowing from the public, or increasing the money supply), will have long-term disadvantages. Classical economists believe that active fiscal and monetary policies do more harm to the economy in the long run compared to the benefits they produce in the short run.