A discretionary fiscal policy is a government policy that changes government spending or taxes. Its purpose is to expand or shrink the economy as needed.
The output is determined by the level of Aggregate Demand (AD), so a discretionary fiscal policy can be used to increase Aggregate Demand and thus also increase the output. This measure would help to close the deflationary gap.
Discretionary Fiscal Policy is a demand-side policy that uses government spending and taxation policy to influence aggregate demand.
Contractionary Discretionary Fiscal Policy
When an economy is in a state where growth is getting out of control and therefore causing inflation and asset price bubbles, a contractionary fiscal policy can be used to rein in the inflation to a more sustainable level. A Contractionary Discretionary Policy will lower government spending and/or increase taxation. This policy will shift Aggregate Demand to the left (a decrease).
A fiscal policy is said to be tight or contractionary when revenue is higher than spending (i.e., the government budget is in surplus) and loose or expansionary when spending is higher than revenue (i.e., the budget is in deficit). The focus is not on the level of the deficit, but on the change in the deficit. A reduction of the deficit from $200 billion to $100 billion is said to be contractionary fiscal policy, even though the budget is still in deficit.
Expansionary Discretionary Fiscal Policy
Since, Aggregate Demand = Consumption + Investment + Government Spending + Net Exports, an Expansionary Policy will shift Aggregate Demand to the right. This kind of policy involves decreasing taxes and/or increasing government spending.
An Expansionary Discretionary Fiscal Policy is typically used in a recession. A decrease in taxation will lead to people having more money and consuming more. This should also increase aggregate demand and could lead to higher economic growth. However, it can also lead to inflation because of the higher demand in the economy.
Criticisms of Discretionary Fiscal Policy
1. Time Lag
Fiscal Policy is characterized by a time lag, which is the time between implementation of a policy and the actual effects being felt in the economy.
2. Expansionary Bias
It has an expansionary bias, no government or politician would implement a contractionary policy, so this means that expenditure will keep rising and taxes would probably not rise too.
A contractionary policy is difficult to implement because no one wants cuts in spending; education, defense and health. It also can’t be maintained indefinitely. It is considered to be a short term tool.
4. Trade Deficit
Expansionary fiscal policy can lead to a higher trade deficit, as higher income leads to more expenditure on imports and a higher negative trade balance.
5. Crowding Out
Expansionary policy may lead to crowding out. Crowding out occurs when a big government borrows money which leads to higher interest rates for the private sector, which leads to less private investment.