8. Active and Discretionary Fiscal Policy
r. explain the implementation of fiscal policy and difficulties of implementation;
s. determine whether a fiscal policy is expansionary or contractionary;
What is the primary concern around implementing discretionary fiscal policy?
Time lags. You don't want policy to be implemented at the wrong time. Policy changes take time; thus, when they take effect, the recession or inflationary overheating may have passed. For example, during an economic downturn, a government uses expansionary fiscal policy to stimulate aggregate demand. Suppose, by the time the expansionary fiscal policy starts to exert its primary impact, the economy's self-corrective mechanism has restored full employment capacity. Therefore, the stimulus injected by expansionary fiscal policy will result in excessive demand and inflation, causing more economic instability.
What are the three primary kinds of time lags that affect fiscal policy implementation timing?
1. Recognition lag. It takes time for everybody to see and agree on policy. Forecasting a forthcoming recession or boom is a highly imperfect science.
2. Action lag. There is generally a lag between the time when the need for a fiscal policy change is recognized and the time when it is actually instituted.
3. Impact lag. Even after a policy is adopted, it may be 6 to 12 months before its major impact is felt.
What are automatic stabilizers? What are some examples?
Automatic stabilizers apply stimulus during a recession and restraint during a boom even though no legislative action has been taken. Their major advantage is that they institute counter-cyclical fiscal policy without the delays associated with policy changes that require legislative action. Some examples are:
- During a recession, they trigger government spending without the authorization of Congress (unemployment compensation and welfare programs).
- During inflationary overheating, they take spending power out of the economy without the delays caused by legislative actions, thereby minimizing the problem of proper timing.
- Income taxes
- Transfer payments