Question

Define discretionary fiscal policy and discuss the problems of lags and crowding out.

Answer 1

discretionary fiscal policies are the policies taken up by the government to regulate the economy and help it to achieve the desired level of equilibrium output, price and employment level in the economy. Discretionary fiscal policies involve making changes in government spending and or taxation to regulate the economy. When a government increases government spending and or decrease the tax rates as a part of discretionary fiscal policies, then aggregate demand is stimulated and new jobs are created. As a result, real output in the economy increases. It happens, when economy passes through the recession. When economy is already expanding, then government decreases spending and or increases tax to control the economy in terms of price stability. It happens when there is an inflationary gap.

Though, discretionary fiscal policies by the government face problems of lags and crowding out. There are inside lag and outside lag. Inside lag refers to the time taken up by the government to recognize the problem. Longer the inside lag, will create more damage to the economy. The outside lag refers to the time taken up by the economy to show the impact of discretionary fiscal policies. A longer inside lag, reduces the impact of the policies and outside lag also increases. So, it is the government who should recognize the economic problem quickly and take the action to get results.

Crowding out effect is a phenomenon that says that government spending discourages private investments. Since funds for borrowing are limited, and if government spends by borrowing, then lesser funds and at higher rates are available to the private firms. Hence, benefits gained from spending is offset by the loss due to decreased private investment. So, the government has to be very careful when it increases the spending.