Contractionary Fiscal Policy 

This type of policy is exercised in times of demand-pull inflation. 

The government can do one of the following:

• decrease government spending

• increase taxes

• do a combination of both

Decreased Government Spending

When the government spends less than the amount of tax revenues, there is a budget surplus.

A decrease in government spending directly causes a decrease in the aggregate demand to the left (AD1 to AD2).  The multiplier process magnifies the initial change in spending, and therefore, the aggregate demand further decreases to AD3.

Increased Taxes

The same result above can also be achieved by increase taxes.

A larger tax increase than a decrease in government spending is necessary to achieve the same amount of leftward shift.

For example, if the MPC is 0.75, taxes must increase by $6.67 billion to have an decrease of %5 billion in consumption.

How does the government do with a Surplus?

• the Federal government can retire outstanding debt

• allow the money to stand idle.  This is called impounding.  This is more contractionary than retiring debt.

Criticisms and Complications of Fiscal Policy

Timing Problems

• Recognition Lag - it takes time for economists to recognize a recession is occurring

• Administrative Lag - it takes time for the government to act

• Operational Lag - it takes time for the changes to take effect

Crowding Out Effect

This occurs under an expansionary fiscal policy.  If the government enters the money market to finance the deficit, the government will crowd out investors.  The increased demand for money raises interest rates.  Because investment is inversely related to interest rates, investment will decrease.  This will offset the effects of an expansionary fiscal policy - the aggregate demand curve moves slightly to the left.

Net Export Effect

This occurs under an expansionary fiscal policy.  If the government enters the money market to finance the deficit, interest rates will rise.  The higher interest rate causes the dollar to appreciate.  Therefore, net exports decline, and aggregate demand decreases, which offsets the effects of expansionary fiscal policy.

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