2. Contractionary Fiscal Policy
- Contractionary fiscal policies include increasing taxes or decreasing government spending with the aim of decreasing AD
- AD= household consumption (C) + firms investment (I) + government spending (G) + exports (X) - imports (M)
- Changes to fiscal policy can influence government spending or consumption or investment
- Changing taxation can influence household consumption and the investment by firms
- Contractionary fiscal policies aims to shift aggregate demand (AD) to the left
Keynesian diagram illustrating how a contractionary fiscal policy aims to decrease real GDP (YFE →Y1) and average price levels (AP1 →AP2)
Diagram Analysis
- The economy is initially in macroeconomic equilibrium AP1YFE - an inflationary output gap is developing
- The economy is booming and the Government is wanting to lower inflation towards its target of 2%
- The Government increases the rate of income tax
- Higher tax rates cause households to have less discretionary income causing consumption to decrease
- Aggregate demand decreases from AD1→ AD2
- The economy reaches a new equilibrium at AP2Y1 - a lower average price level and a smaller level of national output
Examples of the Impact of Contractionary Fiscal Policy
Example 1: The Government increases the rate of income tax
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Effect on the economy
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Households pay more tax → discretionary income reduces → consumption reduces → AD reduces
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Impact on macroeconomic aims
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- Economic growth slows down
- Inflation eases
- Unemployment may increase as output is falling and fewer workers are required
- Net external demand Improves (with less income, imports may fall)
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Example 2: The Government freezes/reduces public sector workers pay
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Effect on the economy
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Wages stagnate or reduce → Consumer confidence falls → consumption decreases → AD decreases
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Impact on macroeconomic aims
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- Economic growth slows down
- Inflation eases
- Unemployment may increase as output is falling
- Net external demand improves (with less income, imports may fall)
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Example 3: The Government cuts Government Spending in their Budget
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Effect on the economy
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Less demand for goods/services → less income for firms → output and profits decrease → AD decreases
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Impact on macroeconomic aims
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- Economic growth slows down
- Inflation eases
- Unemployment may increase as output is falling
- Net external demand may Improve (with less income, imports may fall)
- Less corporation tax available for redistribution
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