Discretionary Fiscal Policy vs. Automatic Stabilizers

by Andra Picincu - Updated July 26, 2018
Automatic stabilizers are designed to take effect during certain economic conditions.

Your earning potential as a business owner depends on a variety of factors, including your country's fiscal policy. Any changes in government spending and taxation will impact your revenue as well as your customers' purchasing power. For this reason, it's important to have a good understanding of the discretionary fiscal policies and automatic stabilizers in macroeconomics. This will allow you to make smarter investments and to keep your business thriving.

What Are Discretionary Fiscal Policies?

Discretionary fiscal policies have the role to stabilize the economy. They come into effect when the government passes new laws that change tax or spending levels. In general, these measures are taken during either recessions or booms.

For example, the government may implement this type of fiscal policy during an economic crisis to increase aggregate demand. If the economy is booming, these measures will help restrain aggregate demand. They are meant to close an inflationary or a recessionary gap. Therefore, a discretionary fiscal policy will stabilize the economy most when surpluses are incurred during inflation and deficits during recessions.

In general, it takes anywhere from six to 12 months after implementing policy changes to experience major improvements. Certain measures, such as varying the expenditure programs and tax rates, may have temporary stabilizing effects. For instance, the government can reduce taxes during times of recession to prevent income and demand from falling.

The Role of Automatic Stabilizers in Macroeconomics

Like discretionary fiscal policies, automatic stabilizers have the role to balance output and demand. The difference is that the changes in government spending and tax rates occur without any deliberate legislative action. In other words, Congress does not have to vote on them. According to the automatic stabilizers definition, these measures may include (but are not limited to) employment incentives, tax cuts, progressive taxation, subsidies to farmers and unemployment compensation.

For example, when the economy slows down and people lose their jobs, the government will automatically spend more on unemployment benefits. During economic growth, people will earn more and pay higher taxes while unemployment rates will drop. Therefore, the government will spend less on unemployment compensation.

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The Limitations of Automatic Stabilizers

A limitation of the automatic stabilization policy is that it doesn't work if inflation is caused by factors other than those affecting aggregate demand. Discretionary fiscal policies, on the other hand, can address economic issues that are not tied to the aggregate demand.

Additionally, automatic stabilizers are not an option in less-developed countries. They are only an option in advanced economies. Furthermore, they may have an exaggerated effect on government finances.

For instance, government borrowing during times of recession increases, which in turn limits the funds available to the private sector for research, investments and other factors that would otherwise stimulate economic growth. Whenever government expenditure increases, the money has to come from somewhere.

Both automatic stabilizers and discretionary fiscal policies have their perks and limitations. One thing is for sure: Automatic stabilizers alone are not enough to correct the problem during times of recession or inflation. For this reason, government intervention may be necessary in order to stabilize the economy.

About the Author

Andra Picincu is a digital marketing consultant with over nine years of experience. She works closely with small businesses and large organizations alike to help them grow and increase brand awareness.

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