Discretionary Policy
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Transcript of Discretionary Policy
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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.
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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
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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.
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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.