If inflation threatens, the central bank uses contractionary monetary policy to reduce the money supply, reduce the quantity of loans, raise interest rates, and shift aggregate demand to the left. Fiscal policy is another macroeconomic policy tool for adjusting aggregate demand by using either government spending or taxation policy. Expansionary fiscal policy increases the level of aggregate demand, through either increases in government spending or reductions in tax rates. Expansionary policy can do this by 1 increasing consumption by raising disposable income through cuts in personal income taxes or payroll taxes; 2 increasing investment spending by raising after-tax profits through cuts in business taxes; and 3 increasing government purchases through increased federal government spending on final goods and services and raising federal grants to state and local governments to increase their expenditures on final goods and services.
Contractionary fiscal policy does the reverse: it decreases the level of aggregate demand by decreasing consumption, decreasing investment, and decreasing government spending, either through cuts in government spending or increases in taxes. Consider first the situation in Figure , which is similar to the U. At the equilibrium E 0 , a recession occurs and unemployment rises. In this case, expansionary fiscal policy using tax cuts or increases in government spending can shift aggregate demand to AD 1 , closer to the full-employment level of output.
In addition, the price level would rise back to the level P 1 associated with potential GDP. Should the government use tax cuts or spending increases, or a mix of the two, to carry out expansionary fiscal policy? During the Great Recession which started, actually, in late , the U. The consensus view is that this was possibly the worst economic downturn in U.
The choice between whether to use tax or spending tools often has a political tinge. As a general statement, conservatives and Republicans prefer to see expansionary fiscal policy carried out by tax cuts, while liberals and Democrats prefer that the government implement expansionary fiscal policy through spending increases.
At the same time, however, the federal stimulus was partially offset when state and local governments, whose budgets were hard hit by the recession, began cutting their spending.
However, advocates of smaller government, who seek to reduce taxes and government spending can use the AD AS model, as well as advocates of bigger government, who seek to raise taxes and government spending.
Economic studies of specific taxing and spending programs can help inform decisions about whether the government should change taxes or spending, and in what ways. Ultimately, decisions about whether to use tax or spending mechanisms to implement macroeconomic policy is a political decision rather than a purely economic one.
Fiscal policy can also contribute to pushing aggregate demand beyond potential GDP in a way that leads to inflation. As Figure shows, a very large budget deficit pushes up aggregate demand, so that the intersection of aggregate demand AD 0 and aggregate supply SRAS 0 occurs at equilibrium E 0 , which is an output level above potential GDP. In this situation, contractionary fiscal policy involving federal spending cuts or tax increases can help to reduce the upward pressure on the price level by shifting aggregate demand to the left, to AD 1 , and causing the new equilibrium E 1 to be at potential GDP, where aggregate demand intersects the LRAS curve.
Again, the AD—AS model does not dictate how the government should carry out this contractionary fiscal policy. Some may prefer spending cuts; others may prefer tax increases; still others may say that it depends on the specific situation. The model only argues that, in this situation, the government needs to reduce aggregate demand.
In this case, expansionary fiscal policy using tax cuts or increases in government spending can shift aggregate demand to AD 1 , closer to the full-employment level of output. In addition, the price level would rise back to the level P 1 associated with potential GDP.
Figure 2. Expansionary Fiscal Policy. The original equilibrium E 0 represents a recession, occurring at a quantity of output Yr below potential GDP. However, a shift of aggregate demand from AD 0 to AD 1 , enacted through an expansionary fiscal policy, can move the economy to a new equilibrium output of E 1 at the level of potential GDP.
Since the economy was originally producing below potential GDP, any inflationary increase in the price level from P 0 to P 1 that results should be relatively small. Should the government use tax cuts or spending increases, or a mix of the two, to carry out expansionary fiscal policy? After the Great Recession of —, U.
This very large budget deficit was produced by a combination of automatic stabilizers and discretionary fiscal policy. The Great Recession meant less tax-generating economic activity, which triggered the automatic stabilizers that reduce taxes. Most economists, even those who are concerned about a possible pattern of persistently large budget deficits, are much less concerned or even quite supportive of larger budget deficits in the short run of a few years during and immediately after a severe recession.
The choice between whether to use tax or spending tools often has a political tinge. As a general statement, conservatives and Republicans prefer to see expansionary fiscal policy carried out by tax cuts, while liberals and Democrats prefer that expansionary fiscal policy be implemented through spending increases. However, state and local governments, whose budgets were also hard hit by the recession, began cutting their spending—a policy that offset federal expansionary policy.
But the AD—AS model can be used both by advocates of smaller government, who seek to reduce taxes and government spending, and by advocates of bigger government, who seek to raise taxes and government spending.
Economic studies of specific taxing and spending programs can help to inform decisions about whether taxes or spending should be changed, and in what ways. Ultimately, decisions about whether to use tax or spending mechanisms to implement macroeconomic policy is, in part, a political decision rather than a purely economic one. Contractionary monetary policy is driven by increases in the various base interest rates controlled by modern central banks or other means producing growth in the money supply.
The goal is to reduce inflation by limiting the amount of active money circulating in the economy. It also aims to quell unsustainable speculation and capital investment that previous expansionary policies may have triggered. In the United States, a contractionary policy is typically performed by raising the target federal funds rate, which is the interest rate banks charge each other overnight, in order to meet their reserve requirements.
The Fed may also raise reserve requirements for member banks, in a bid to shrink the money supply or perform open-market operations, by selling assets like U. Treasuries, to large investors. This large number of sales lowers the market price of such assets and increases their yields, making it more economical for savers and bondholders.
For an actual example of a contractionary policy at work, look no further than As reported by Dhaka Tribune , Bangladesh Bank announced plans to issue a contractionary monetary policy in an effort to control the supply of credits and inflation and ultimately maintain economic stability in the country.
Federal Reserve History. Federal Reserve Bank of St. Dhaka Tribune. Bangladesh Bank. Federal Reserve. Interest Rates. Fiscal Policy. Actively scan device characteristics for identification. Use precise geolocation data. Select personalised content.
The increase in government expenditures should be sufficient to cause the aggregate demand curve to shift to the right from AD 1 to AD 2 , restoring the economy to the natural level of real GDP. This increase in government expenditures need not, of course, be equal to the difference between Y 1 and Y 2. Recall that any increase in autonomous aggregate expenditures, including government expenditures, has a multiplier effect on aggregate demand.
Hence, the government needs only to increase its expenditures by a small amount to cause aggregate demand to increase by the amount necessary to achieve the natural level of real GDP. Keynesians argue that expansionary fiscal policy provides a quick way out of a recession and is to be preferred to waiting for wages and prices to adjust, which can take a long time.
Combating inflation using contractionary fiscal policy. Keynesians also argue that fiscal policy can be used to combat expected increases in the rate of inflation. Suppose that the economy is already at the natural level of real GDP and that aggregate demand is projected to increase further, which will cause the AD curve in Figure to shift from AD 1 to AD 2.
The government can head off this inflation by engaging in a contractionary fiscal policy designed to reduce aggregate demand by enough to prevent the AD curve from shifting out to AD 2. Again, the government needs only to decrease expenditures or increase taxes by a small amount because of the multiplier effects that such actions will have. Secondary effects of fiscal policy.
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