Fiscal Policy

Contractionary Fiscal Policy

Governments pursue a contractionary fiscal policy to decrease aggregate demand when they want to slow economic growth.
In order to slow the economy, governments will pursue contractionary fiscal policy. Contractionary fiscal policy aims to reduce consumer spending and slow economic growth. When demand (and the equilibrium point where AD and AS meet) has increased beyond full-employment GDP, meaning there are more jobs than people to work, an upward pressure is placed on prices and wages. This upward pressure causes inflation, and the circumstance where the equilibrium point is beyond full employment is known as an inflationary gap. In the event of an inflationary gap, the government implements contractionary fiscal policy to slow economic growth and bring the economy back to full employment equilibrium. This may also be good time to reduce deficit spending or pay down the national debt, because consumer spending will balance the change in money spent by the government.

Growth above 2 percent to 3 percent (for the United States) per year can result in undesirable consequences for an economy. First, rapid growth leads to rapid inflation (a consistent rise in the level of prices in an economy). Increases in aggregate demand past full-employment GDP puts pressure on prices and wages throughout the economy, which leads to inflation. Two inflationary periods took place, during World Wars I and II, when growth and increases in aggregate demand were rising rapidly due to needs from the war effort. Unsustainable growth can lead to economic crises when the engine of rapid growth suddenly cuts out. Second, an unemployment rate that is too low, below the natural rate of unemployment, causes labor shortages and difficulty in placing skilled labor in the right jobs. There are less unemployed workers to fill new jobs as the economy expands to meet high demand. In addition, the lack of workers pushes wages higher, which further leads to inflation.

As a result, when governments view growth or inflation as too rapid, they embark on contractionary fiscal policies. These generally involve measures contradictory to expansionary policies: governments raise taxes and cut government spending. Cuts in government spending can take several forms, with different impacts. Consumer demand might be tempered by cuts to social welfare spending or unemployment insurance, for example. Government purchases might be cut to reduce business profits, providing a disincentive to retain and hire workers. Income tax increases, likewise, restrict the amount of disposable income (money after taxes and necessities such as rent) that households have available to spend on consumer goods and encourage saving. Higher corporate tax rates limit business investment and expansion. Whatever measures a government takes, the intent is to reduce aggregate demand by restricting the amount of money in the economy.

Because contractionary policies involve tax increases and cuts to government spending on purchases and welfare programs, contractionary fiscal policies are generally politically unpopular.
The economy starts at an initial equilibrium point where price level (P1) and quantity of output (Y1) sets an equilibrium point above full-employment GDP. This level of aggregate demand will cause an inflationary gap, which is characterized by inflationary increases in the price level. Thus, a contractionary fiscal policy can be executed to shift aggregate demand downward (AD1 to AD2), which will result in a new equilibrium output that occurs at full-employment GDP, corresponding to Y2 and P2. This new equilibrium point is where AD2, SRAS1, and LRAS intersect.