Contractionary fiscal policy: examples and tools

Contractionary fiscal policy consists of increasing taxes and decreasing government spending to reduce the budget deficit. It is usually used in response to an economic downturn (recession) or when there is high inflation. Contractionary fiscal policy is so named because it causes a contraction of the economy due to a contraction in government spending; it is also known as tight or restrictive fiscal policy.

The government and Congress can use contractionary fiscal policy
The government and congress can use contractionary fiscal policy

Contractionary fiscal policy tools

The two common contractionary fiscal policy tools are increased taxation and reduced government spending. These types of fiscal policy tools are very important during inflation and are often used to control inflation as explained in the following sections.

Contractionary fiscal policy is achieved through decreasing government spending or increasing taxes. When restrictive fiscal policy is implemented, the decrease in government spending decreases aggregate demand which causes the economy to slow down. A decrease in government spending also decreases the multiplier effect.

The increase in taxes is known as a contractionary fiscal policy because it causes aggregate demand to go down. When there is an increase in taxes, people have less money to spend which decreases aggregate demand. Tight fiscal policy works in the short run because people are still adjusting to the higher taxes.

Tight fiscal policy does not work in the long run because it causes aggregate supply to decrease. The decreased aggregate supply causes a decrease in output and could possibly lead to a recession.

Contractionary fiscal policy is used to decrease equilibrium GDP, which also has the effect of lowering inflation. This is because an increase in taxes reduces disposable income and therefore reduces the amount of goods people are able to purchase. Similarly, a decrease in government spending has the effect of decreasing aggregate demand.

Effects on aggregate demand and interest rates

A tight fiscal policy has effects on both aggregate demand and interest rates; the government uses this tool to reduce the growth of an overheated economy. Below are the various ways through which aggregate demand and interest rates are affected by a tight fiscal policy.

Contractionary fiscal policy effect on aggregate demand

One common form of contractionary fiscal policy is raising taxes with the aims of:

  1. Reducing people’s disposable income and therefore reducing consumption and aggregate demand and
  2. Increasing government revenue which can be used to pay down the cost of borrowing (because less interest is now being paid on the national debt).

Another method for achieving a tight fiscal policy is to cut government spending. This reduces the amount of money spent by consumers on government services and products, which contributes further to the reduction in aggregate demand.

Contractionary fiscal policies can be contrasted with expansionary fiscal policies, which aim at increasing the size of the economy through increases in aggregate demand.

Contractionary fiscal policy effect on interest rate

A tightening fiscal policy refers to the government taxing more and spending less in order to reduce total demand within an economy. This is generally thought of as being counterproductive, because it reduces economic growth. However, contractionary fiscal policy is recommended when there is high inflation.

When expansionary fiscal policy is utilized, tax revenue decreases and spending increases due to government support for public works programs, social programs or tax breaks. These actions increase the total amount of money within the economy, which lowers interest rates and increases borrowing.

The opposite occurs under restrictive fiscal policy, where individuals pay lower taxes and receive less support from the state. This shift decreases spending and diverts money away from possible investments, thus decreasing the total amount of money in circulation. This reduction in interest rates makes borrowing less attractive.

As the total monetary value decreases, inflation also tends to decrease. However, when expansionary fiscal policy is used too much, contractionary fiscal policy must be implemented to bring back economic growth and control an excessively high inflation rate.

International economics can be used to illustrate the effects of contractionary fiscal policy. An example of contractionary fiscal policy would be the case of Greece in 2008, when it was facing a budget deficit that reached 15 percent of GDP. Due to this, the government imposed higher taxes on consumers and businesses with lower income levels. This decreased consumer spending power, which helped reduce inflation.

The United Kingdom is another good case study of contractionary fiscal policy. In 2010, the United Kingdom’s budget deficit was over 10 percent of GDP, so the government implemented stringent austerity measures to reduce spending and help bring the total amount of money in circulation under control. The unemployment rate rose up to 8 percent but inflation fell.

While contractionary fiscal policy can be effective, it is also likely to cause economic stagnation. It is difficult to predict the magnitude of this effect, because fiscal policy works in an indirect manner with long-term potential effects on an economy.

Three types of contractionary fiscal policy

  1. Tax-based
  2. Expenditure-based
  3. Debt-based

Each of these 3 types of contractionary fiscal policy with their examples in history, would be discussed below.

Contractionary fiscal policy examples in history

Restrictive fiscal policy can also be divided into three sub-categories: tax-based, expenditure-based, and debt-based.

Tax based contractionary fiscal policy

Tax-based contractionary fiscal policy involves decreasing taxes to decrease aggregate demand (e.g., an increase in VAT). This is because when people have less money, they spend less; businesses then experience decreased sales and therefore lower profits leading them to either cut jobs or put expansion plans on hold.

An example of tax-based contractionary fiscal policy occurred in 2009 when the French government wanted to decrease its deficit by reducing taxes. As a result, the VAT was increased from 5.5% to 7%. This had immediate effects on aggregate demand since people had less money to spend and therefore spent less, leading businesses to lower their prices and cut jobs.

Expenditure-based contractionary fiscal policy with example

Expenditure-based contractionary fiscal policy involves decreasing government spending, which has the effect of reducing aggregate demand as described previously. This type of contractionary fiscal policy is often used by governments in an effort to reduce inflation. For example, one way that some countries have tried to decrease inflation is by increasing taxes and decreasing government spending, which leads to a decrease in aggregate demand. The most notable example of this was the fiscal policy implemented by President Herbert Hoover as an attempt to combat the high inflation rates during the Great Depression.

Expenditure-based restrictive fiscal policy can also take place when there is increasing taxation and decreasing government spending. This is often referred to as a ‘balanced budget‘ and is usually accompanied by high unemployment.

Debt-based contractionary fiscal policy with example

A debt-based restrictive fiscal policy involves increasing taxes and decreasing government spending to reduce the budget deficit, but also keeps the size of the deficit constant. The government does this by selling government securities or increasing taxes so that it can pay back debts that it has previously incurred.

A common example of debt-based contractionary fiscal policy is increasing taxes, for example, VAT, to reduce the budget deficit without cutting government spending which would have a big impact on aggregate it has already accumulated. This may involve increasing taxes and government spending simultaneously while also trying to reduce the budget deficit.

For example, in 2011 the US implemented this type of contractionary fiscal policy by cutting $85 billion from federal government spending and raising $18 billion in revenue, mainly through increased taxation. The plan was to decrease the budget deficit from 10.662 trillion in 2011 to about $960 billion in 2012, a decrease of over 9%.

In addition, the austerity measures implemented by some countries have been contractionary fiscal policies that have been used as a means to reduce their budget deficit and control inflation. One example is Greece, where expenditure-based contractionary fiscal policy has been implemented by increasing taxes and decreasing government spending. This policy taken by Greece resulted in a 9% reduction of the budget deficit from 2010 to 2011 according to the European Commission report, “European Economic Forecast – Autumn 2012”.

FAQs

How will a contractionary fiscal policy affect a budget deficit?

A contractionary fiscal policy affects a budget deficit by reducing the amount of money that goes into the government’s treasury during a period of time.

During a restrictive fiscal policy, tax rates are increased and/or government spending is reduced. When there is a budget deficit, it means that the government receives less money than what it spends during a given period of time, so a restrictive fiscal policy is going to reduce government spending and/or increase tax revenue overall. This reduces the deficit overall.

When is contractionary fiscal policy used?

Contractionary fiscal policy is typically used when the economy goes into a recession.
The government reduces the amount of money it lets out to contract the economy and put people back to work. Fiscal policy in this case is referred to as “tight” or aggressive compared to the loosening of fiscal policy during a recession.

What are the effects of contractionary fiscal policy?

The effects of contractionary fiscal policy include austerity measures. When a government uses restrictive fiscal policy it is decreasing its spending or increasing taxes in an attempt to slow the economy and reduce inflation. This is often done when a government is at risk of going into too much debt, which can lead to a sovereign debt crisis.

When does the government assume a contractionary fiscal policy position?

Contractionary fiscal policy (also known as fiscal retrenchment or austerity) is initiated when a government aims to reduce its budget deficit.

A video explaining the AD-AS graph when contractionary fiscal policy is used.

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