What Does Contractionary Fiscal Policy Do

Under what general macroeconomic circumstances could a government pursue an expansionary fiscal policy? When could it resort to a restrictive fiscal policy? Fiscal policy is the use of public spending and fiscal policy to influence the course of the economy over time. Graphically, we see that fiscal policy, whether through changes in spending or taxes, shifts aggregate demand outward in the case of expansionary fiscal policy and inward in the case of contractionary fiscal policy. We know from the chapter on economic growth that over time, the quantity and quality of our resources increases as the population and therefore the workforce grows, as firms invest in new capital and technology improves. This results in regular shifts to the right of the aggregated supply curves, as shown (figure). In addition to maintaining a certain amount of deposits each night, the Fed requires banks to adhere to a « fractional reserve requirement, » that is, they always have a certain amount of money at their disposal in case account holders need their money. But it can adapt and adapt the requirements. Contraction policy is a monetary measure that refers either to a reduction in public spending – especially deficit spending – or to a reduction in the rate of monetary expansion by a central bank. It is a kind of macroeconomic tool to combat rising inflation or other economic distortions caused by central banks or government intervention. The policy of contraction is the exact opposite of expansive politics. First, consider the situation in (figure), which resembles the U.S. economy during the 2008-2009 recession. The intersection of aggregate demand (AD0) and total supply (SARS0) is below the level of potential GDP, as shown in the LRAS curve. In equilibrium (E0), a recession occurs and unemployment rises.

In this case, expansionary fiscal policies that take advantage of tax cuts or increases in government spending can shift aggregate demand to AD1, closer to the full employment level of output. In addition, the price level would rise to the P1 level associated with potential GDP. Of course, the trick of a contractionary monetary policy is to gently contain the galloping economy, but never to stop it completely in its tracks. Again, the AD-AS model does not dictate how the government should conduct this restrictive fiscal policy. Some may prefer spending cuts; others may prefer tax increases; Still others will say that it depends on the specific situation. The model only argues that in this situation, the government must reduce aggregate demand. What is the main reason for the contraction of fiscal policy in times of strong economic growth? If a country`s GDP grows too fast, causing inflation to exceed a desirable rate of 2%, central banks will implement a monetary policy of contraction. Chance, Brian and Dan Wilson. Federal Reserve Bank of San Francisco, « FRBSF Economic Letter – U.S. Fiscal Policy: Headwind or Tailwind? » Last modified on July 2, 2012. www.frbsf.org/economic-research/publications/economic-letter/2012/july/us-fiscal-policy/.

For example, private business investment in physical capital in the U.S. economy exploded in the late 1990s, from 14.1 per cent of GDP in 1993 to 17.2 per cent in 2000 before falling back to 15.2 per cent in 2002. Conversely, inflationary increases in the price level will occur when changes in aggregate demand precede an increase in total supply. Economic cycles of recession and recovery are the result of changes in aggregate supply and demand. When this happens, the government can choose to use fiscal policy to remedy the difference. The goal is to slow the pace of the economy by reducing the money supply or the amount of easily depositing liquidity and funds circulating throughout the country. This is the opposite of expansionary monetary policy. How will the government`s cuts to budget spending affect the federal government`s expansive policies? But when inflation exceeds its target growth rate of 2%, it acts as a warning – and becomes the main catalyst for the implementation of a contractionary monetary policy. Indicate whether an expansionary or contractionary fiscal policy seems most appropriate in response to each of the following situations, and describe a graph with aggregated demand and supply lines to illustrate your response: Aggregate demand and aggregate supply do not always go well together.

Think about what causes changes in aggregate demand over time. As the total supply increases, incomes tend to increase. This tends to increase consumer and investment spending and shift the aggregate demand curve to the right, but over a period of time, the same amount as total supply may not change. What happens to government spending and taxes? The government spends money to pay for the ordinary affairs of government – things like national defense, social security, and health care, as shown (figure). Tax revenues partly cover these expenses. This can result in an increase in aggregate demand that is more or less pronounced than the increase in total supply. Expansionary fiscal policy increases the level of aggregate demand, either by increasing government spending or by lowering tax rates. Expansionary policies can achieve this by (1) increasing consumption by increasing disposable income through reductions in income tax or payroll taxes; (2) Increase capital expenditures by increasing after-tax profits by reducing corporate taxes; and (3) Increase government procurement by increasing federal spending on final products and services, and increase federal subsidies to state and local governments to increase their spending on final products and services. Restrictive fiscal policy does the opposite: it reduces the level of aggregate demand through lower consumption, lower investment and lower public spending, either through cuts in public spending or through tax increases.

The aggregate supply and demand aggregate model is useful for assessing whether expansionary or contractionary fiscal policy is appropriate. The opposite of contractionary monetary policy is expansionary monetary policy. The conflict over which policy tool to use can be frustrating for those who want to categorize the economy as « liberal » or « conservative, » or who want to use economic models to argue against their political opponents. However, proponents of a smaller government who want to cut taxes and government spending can use the AD AS model, as can advocates of a larger government who want to raise taxes and government spending. Economic studies of specific tax and spending programs can help make decisions about whether and how the government should change taxes or spending. Ultimately, deciding whether to use fiscal or spending mechanisms to implement macroeconomic policies is political rather than purely economic. Restrictive monetary policy is a macroeconomic tool that a central bank – in the United States, the Federal Reserve – uses to reduce inflation. The purpose of contractionary monetary policy is to prevent these brutal shocks. To slow economic growth, the central bank must curb demand by making it more expensive to buy goods and services, at least for a while.

If contraction policies reduce the degree of displacement in private markets, this can have a stimulating effect by allowing the private or non-governmental part of the economy to grow. This was true during the forgotten depression of 1920-1921 and in the period immediately after the end of World War II, when leaps in economic growth followed massive cuts in public spending and rising interest rates. Runaway inflation is not a common problem. This, combined with the fact that governments want an economy to grow, means that contractionary monetary policy has not been applied as often. Fiscal policy can also help push aggregate demand beyond potential GDP in a way that leads to inflation. As shown (figure), a very large budget deficit leads to an increase in aggregate demand, so that the overlap of aggregate demand (AD0) and aggregate supply (SARS0) occurs at equilibrium E0, which is a level of output above potential GDP. Economists sometimes call this an « overheated economy » where demand is so high that there is upward pressure on wages and prices, which leads to inflation. In this situation, restrictive fiscal policies that include federal spending cuts or tax hikes can help ease upward pressure on price levels by shifting aggregate demand to the left, towards AD1, and ensuring that the new E1 balance is in potential GDP. where aggregate demand intersects with the LRAS curve.

Expansionary fiscal policy increases aggregate demand, either through increased government spending or tax cuts. Expansionary fiscal policy is best suited when an economy is in recession and produces below its potential GDP. Restrictive fiscal policy reduces the level of aggregate demand, either through cuts in public spending or through tax increases. .