Discretionary and Automatic Fiscal Policy

Discretionary Fiscal Policy: Government Spending

1) Close Recessionary Gap-> G increases => AD increases *Use Expansionary Fiscal Policy


2) Close Expansionary Gap-> G decreases => AD decreases * Use Contractionary Fiscal Policy


3) Supply-Side-> Government spending on infrastructure, capital goods, and education (human capital). By doing this AS, AD, and Potential GDP will increase.
*Difficulty: With supply side we want demand to go up the same as supply or else inflation will occur.

Discretionary Fiscal Policy: Taxation

1) Close Recessionary Gap-> T decreases => AD increases *Use Expansionary Fiscal Policy

2) Close Expansionary Gap-> T increases => AD decreases * Use Contractionary Fiscal Policy

3) Supply Side-> Cut business and sales taxes => AS increases (Recessionary Gap)
Raise business and sales taxes => AS decreases (Expansionary Gap)

Automatic Fiscal Policy:
It is the way to use government spending and changes in taxation to stabilize the economy without having to use discretionary fiscal policy.
1) Progressive tax system:
a. Expansionary period-> Income goes up, pushed into higher tax bracket, pay more taxes
  • Disposable income isn't growing as much as your pay check; this smooths out the business cycle.

b. Contractionary period-> Income goes down, pushed into lower tax bracket, pay less taxes.
  • Disposable income isnt falling as much as our paycheck; smooths out bottom of business cycle


2) Government Assistant to Agriculture:
Subsidies are tied to commodity prices (transfer payments)
a. Expansionary period-> AD increases => prices increasing => farmers income increases => subsidies decrease
*Farmers income grows but not too fast which stops inflation

b. Contractionary period-> AD decreases => prices decreasing => farmers income decreases => subsidies increase
*Farmer isn't hurt by recession


3) Employment Insurance (EI)
a. Expansionary period-> More jobs, more revenue for EI
*Fight Inflation (earning less + buying less)


b. Contractionary Period-> Less jobs, more people collecting EI
*This is a buffer (can still buy necessities)





Stephanie Powers, "Fiscal Policy", Red Deer College, accessed April 15th, 2012.




What is automatic fiscal policy? Give an example of automatic fiscal policy? What happens during recessionary periods? What happens during expansionary periods?**

  • Automatic fiscal policy is a way to use government spending and changes in taxation to stabilize the economy without having to use discretionary fiscal policy. Automatic fiscal policy stimulates aggregate demand during recessionary periods through deficit spending. Automatic fiscal policy reduces aggregate demand during expansionary periods by adding to the government surplus. For example, the progressive tax system in Canada increases the government surplus during expansionary periods because inflation causes households to move into higher tax brackets, households then have to pay higher taxes. Higher taxes reduce the level of disposable income, which means households are spending less (decrease in aggregate demand). During recessionary periods, income levels fall causing households to move into lower tax brackets. Households pay less taxes, which gives them more disposable income and increases aggregate demand. Lower tax revenue causes the government to resort to deficit spending.


Stephanie Powers, Practice Final: Version A, Accessed April 16, 2012