Question

Please read the following four examples below. Please identify what they are (i.e., discretionary fiscal policy, monetary policy, or automatic stabilizer) and explain why.  

a) A terrible recession occurs as a result of a bubble in the housing market bursting, and government-funded unemployment compensation is paid out to laid-off workers. (5 points)

b) As the economy heats up, the resulting increase in equilibrium GDP results in higher income tax payments, which dampen consumption spending somewhat. (5 points)

c) To stem an overheated economy, the president, using special powers granted by Congress, authorizes emergency impoundment of funds that Congress had previously authorized for spending on some government programs to help reduce government spending (G), and thus help reduce inflation. (5 points)

d) The Federal Reserve decides to increase the money supply in order to help lower interest rates and stave off a more severe recession. (5 points)

Answer 1

(a)

Changes in business cycle brings automatic changes in some government expenditure.

These government expenditures are termed as automatic stabilizers.

These expenditures increases automatically during recession and decreases automatically during expansion.

Unemployment compensation is one such expenditure. During recession, unemployment rate is high, so, unemployment compensation paid by government increases while during expansion, unemployment rate is low, so, unemployment compensation paid by government decreases.

Thus, this example represents automatic stabilizer.

(b)

Changes in business cycle brings automatic changes in the some sources of government revenue.

These sources of government revenue are termed as automatic stabilizers.

These revenues increases during expansion and decreases during recession.

Income tax revenue is one such automatic stabilizer.

During expansion, incomes are increasing, so, income tax revenue also increases.

During recession, incomes are decreasing, so, income tax revenue also decreases.

Thus, this example represents automatic stabilizer.

(c)

When President or government take deliberate actions to stabilize economy then such actions are termed as discretionary fiscal policy.

In given case, President is taking deliberate policy actions to reduce inflation.

Thus, this example represents discretionary fiscal policy.

(d)

When Federal Reserve takes deliberate policy actions to stabilize the economy then such policy actions are termed as monetary policy actions.

In the given case, Federal Reserve is taking action to influence the money supply to stave off a more severe recession.

Thus, this example represents monetary policy.