7/30/2019 Discretionary Policy

http://slidepdf.com/reader/full/discretionary-policy 1/4

Definition: Discretionary fiscal policy is the portion of the Federal

government's actions that can be changed year to year by Congress and

the President. It is usually executed through each year's budget or

through changes in the tax code.Discretionary fiscal policy can either be used to expand the economy or

contract it. Expansionary fiscal policy is when the Federal government

increases spending or decreases taxes. This usually spurs economic

growth, creating more profitable businesses and more jobs. If both are

done simultaneously, it drives the economy even faster. However, it also

creates a budget deficit, because the government is spending more than

it receives in taxes. This works well, until the debt-to-GDP ratio nears100%. At that point, investors start to worry that the government won't

repay itssovereign debt, and aren't as eager to buy government bonds to

finance the debt.

Contractionary fiscal policy is the opposite, and has the opposite effect.

It's when the Federal government cuts spending or increases taxes, and it

slows economic growth. That's because there is less money in taxpayers'

pockets, and fewer contracts going to government contractors andemployees.

Unfortunately, the political process ensures that discretionary fiscal

policy will nearly always be expansionary. Why? Because lawmakers

get elected by spending money. That's how they reward voters, special

interest groups and those who donate to campaigns. In other words,

everyone wants to see the budget cut, just not their portion of the budget.

Discretionary fiscal policy is supposed to work like a counterweight to

the business cycle. During boom years, Congress and the President

should cut spending and programs to cool the economy. If done well, the

reward will be an ideal economic growth rate of around 2-3% a year.

7/30/2019 Discretionary Policy

http://slidepdf.com/reader/full/discretionary-policy 2/4

Instead, politicians keep spending, stimulating the economy even more

and creatingasset bubbles, and ensuring a more devastating bust.

Discretionary policies are similar to "feedback-rule policies" used by

the Federal Reserve to achieve price level stability. "Discretionary policies"

refer to actions taken in response to changes in the economy, but they do

not follow a strict set of rules, rather, they use subjective judgment to treat

each situation in unique manner. In practice, most policy changes are

discretionary in nature. Policy makers use auto stabilizers to adjust the

aggregate demand.

"Discretionary policy" can refer to decision making in both monetary

policy and fiscal policy. 

Discretionary Budget

The most noticeable example of discretionary fiscal policy is the

discretionary budget. These are expenditures within the U.S. budget that

are within the appropriations bills that are negotiated between the

Branches of Congress and the President's Office each year. It includesmilitary spending, and nearly all other Federal departments.

It does not include mandatory programs, such as Social Security,

Medicare, and Medicaid. These have been mandated by Federal law, and

can only be changed through a Congressional vote amending or

revoking that law.

Taxation

Discretionary fiscal policy can also be implemented through changes in

taxation. When taxes are raised or new taxes are levied, that's

contractionary fiscal policy. Higher taxes reduce the amount of 

7/30/2019 Discretionary Policy

http://slidepdf.com/reader/full/discretionary-policy 3/4

disposable income available for families or businesses to spend. This

decreases demand, slowing economic growth.

When taxes are lowered or eliminated, that's expansionary fiscal policy.

It puts more money into the economy by allowing companies and peoplethe ability to spend more for things they want.

Supply-side economics argues that one of the best ways to stimulate the

economy is through reducing taxes. Lowering taxes give consumers and

businesses more money to spend, increasing demand. Over time, this

stronger economic growth will make up for the government revenue lost

by generating a larger tax base. However, it will only work if taxes were

high in the first place. According to the underlying economic theory,

the Laffer Curve, the highest tax rate must be above 50% for supply-side

economics to work.

Discretionary Fiscal Policy and Monetary Policy

At its best, discretionary fiscal policy should work in alignment with

monetary policy enacted by the Federal Reserve. If the economy is

growing too fast, fiscal policy can apply the brakes by raising taxes orcutting spending at the same time the Fed enacts contractionary

monetary policy by raising the Fed funds rate. 

If the economy is in a recession, discretionary fiscal policy can lower

taxes and increase spending while the Fed enacts expansive monetary

policy as it lowers the Fed funds rate, or pumps liquidity into the

financial system with its other tools, such as quantitative easing. When

working together, fiscal and monetary policy can act very powerfully to

take the pain out of the stages of the business cycle.

However, since politicians usually enact expansive fiscal policy no

matter what, then it's up to the Fed to manage the economy alone.

7/30/2019 Discretionary Policy

http://slidepdf.com/reader/full/discretionary-policy 4/4

Relentless expansionary fiscal policy forces the Federal Reserve to use

contractionary monetary policy as a brake when the economy is

booming. Higher interest rates reduce capital and liquidity, especially

for small business and in the housing market. This ties the hands of theFed, reducing its flexibility. Article update March 7, 2012 

Examples: 

A large part of discretionary fiscal policy is the defense budget. This is

the largest part of thediscretionary spending portion of the U.S. Budget.