What Is the Purpose of a Contractionary Fiscal Policy

The objective of an expansionary fiscal policy is to reduce deflation and unemployment and increase economic growth. The implementation of expansionary fiscal policy often results in deficits for the government, as it spends more than it accumulates in tax revenue. Governments pursue expansionary fiscal policies to pull an economy out of recession and close the negative output gap. The objective of restrictive monetary policy is to prevent these gross shocks. To curb economic growth, the central bank must dampen demand by making goods and services more expensive – at least for a while. Fiscal policy is the use of government spending and fiscal policy to influence the trajectory of the economy over time. Automatic stabilizers, which we heard about in the last section, are a passive form of fiscal policy, because once the system is in place, Congress doesn`t need to take any further action. On the other hand, discretionary fiscal policy is active fiscal policy that uses expansionary or restrictive measures to speed up or slow the economy. Figure 2. Expansionary fiscal policy.

The initial equilibrium (E0) represents a recession that occurs at a volume of output (year) below potential GDP. However, a shift in aggregate demand from AD0 to AD1, caused by expansionary fiscal policy, can lead the economy to equilibrium output of E1 at the level of potential GDP. Given that the economy was originally producing below potential GDP, an inflationary increase in the price level from P0 to P1 is expected to be relatively small. Restrictive policy is a monetary measure that refers either to a reduction in government spending – especially deficit spending – or to a reduction in 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. Contraction policies are the exact opposite of expansionist policies. Country C has been experiencing a boom since February 2022, the government decided to implement a restrictive fiscal policy by eliminating the benefit program, which provides households with an additional monthly income of $ 2500. Eliminating the $2500 social benefit will reduce household spending, which will help reduce the rise in inflation. A well-known example of restrictive monetary policy used to control inflation dates back to the late 1970s. From 1972 to 1973, inflation rose from 3.4% to 8.7%. Expansionary fiscal policy is implemented through ————— in taxes, public spending ——————– spending, and purchasing. These annual budget deficits worsen U.S.

debt. That`s more than $27 trillion, more than the U.S. produces in a year. In the long term, the debt ratio is unsustainable. Over time, buyers of U.S. Treasuries will fear not being repaid. They will charge higher interest rates to offset the additional risk. Let`s take a look at some examples of expansionary and restrictive fiscal policy! Keep in mind that the main objective of expansionary fiscal policy is to stimulate aggregate demand, while restrictive fiscal policy reduces aggregate demand. To cool this overheated economic engine, a country`s central bank will implement a restrictive monetary policy to slow rapid growth and rising prices. All other things being equal, restrictive fiscal measures would reduce the budget deficit. Under certain circumstances, these measures could turn a deficit into a surplus.

It depends on the extent to which the measures reduce expenditure or increase revenue. This very high budget deficit was caused by a combination of automatic stabilizers and discretionary fiscal policy. The Great Recession led to a decline in tax-generating economic activity, triggering automatic stabilizers that reduced taxes. Most economists, even those worried about a possible pattern of persistent budget deficits, are much less concerned or even in favor of larger short-term budget deficits of a few years during and immediately after a severe recession. Elected officials are much less inclined to pursue restrictive fiscal policies than expansionary ones. That`s because voters don`t like tax increases. They are also protesting against benefit cuts caused by cuts in government spending. As a result, politicians who pursue restrictive policies will soon be removed from office. Expansionary fiscal policy occurs when Congress cuts tax rates or increases government spending, shifting the entire demand curve to the right. Restrictive fiscal policy occurs when Congress raises tax rates or cuts government spending, shifting aggregate demand to the left.

Tight fiscal policy addresses an output gap of _____; An expansionary fiscal policy closes an output gap of ____. These measures effectively reduce the money supply. Individuals and businesses have less money at their disposal, and what they buy – directly or through borrowing – costs them more. Contraction policies occurred particularly in the early 1980s, when then-Federal Reserve Chairman Paul Volcker finally halted the rapid inflation of the 1970s. At its peak in 1981, the federal fund`s target interest rates were around 20 per cent. The measured inflation rate fell from almost 14% in 1980 to 3.2% in 1983. Restrictive monetary policy is driven by increases in various policy rates controlled by modern central banks or by other means that lead to money supply growth. The aim is to reduce inflation by limiting the amount of active money circulating in the economy. It also aims to stifle the unsustainable speculation and capital investment that previous expansionary measures may have triggered.

Do you live in an economy that is in recession or crippled by inflation? Have you ever wondered what governments are actually doing to restore an economy that is in recession? Or an economy crippled by inflation? Are governments the only entities that have exclusive control over restoring stability to an economy? An expansionary and restrictive fiscal policy is the answer to all our problems! Well, maybe not all of our problems, but these macroeconomic tools used by our policymakers and central banks can certainly be the solution to change the direction of an economy. Ready to learn more about the difference between expansionary and restrictive fiscal policy and more? So keep scrolling! Figure 3. a restrictive fiscal policy. The economy starts at equilibrium of the amount of production Yr, which is greater than potential GDP. Extremely high aggregate demand will lead to inflationary increases in the price level. Restrictive fiscal policy can shift aggregate demand down from AD0 to AD1, resulting in a new equilibrium of E1 output that occurs at potential GDP. In addition to an expansionary and restrictive fiscal policy, monetary policy is another instrument for influencing the economy. Both types of measures can be used hand-in-hand to stabilize an economy in recession or booming. Monetary policy is the effort of a country`s central bank to stabilize the economy by influencing the money supply and influencing credit through interest rates.

An expansionary fiscal policy increases the level of aggregate demand, either through increased government spending or tax cuts. An expansionary policy can achieve this by: Restrictive fiscal policy generally slows economic growth. Cuts in government spending slow down an economy, as does increases in tax revenues. However, restrictive fiscal policy is typically used to slow down a fast-growing economy. Theoretically, politics could slow the economy, but it would only bring it to a healthy growth rate. In Figure 1, the economy is in a negative output gap, represented by coordinates (Y1, P1), and output is below potential output. The implementation of an expansionary fiscal policy shifts aggregate demand from AD1 to AD2. Production is now in a new equilibrium at Y2 – closer to potential output. This policy would lead to an increase in consumers` disposable income, thereby increasing spending, investment and employment. First, let`s look at the situation in Figure 2, which resembles the U.S.

economy during the 2008-2009 recession. The intersection of aggregate demand (AD0) and total supply (AS0) is below potential GDP. At equilibrium (E0), a recession occurs and unemployment rises. (The figure uses the upward-slanted AS curve, which is associated with a Keynesian approach to economics, rather than the vertical AS curve, which is associated with a neoclassical approach, since we focus on macroeconomic policy on the short-run business cycle, not the long run.) In this case, expansionary fiscal policy with tax cuts or increases in government spending can shift aggregate demand towards AD1, closer to the full employment level of output. In addition, the price level would return to the P1 level associated with potential GDP. President Bill Clinton has taken advantage of the contraction policies by cutting spending in several key areas. First, it required social assistance recipients to work within two years of receiving social benefits. After five years, the benefits were eliminated. It also raised the highest tax rate from 31% to 39.6%. It is because they have to comply with balanced budget legislation. They are not allowed to spend more than they receive in taxes. This is good policy, but the downside is that it limits the ability of legislators to recover during a recession.

If they do not have a surplus when the recession hits, they must cut spending exactly when they need it most.