FISCAL POLICY

Contractionary Fiscal Policy

• When aggregate demand rises beyond what the economy can potentially produce by fully employing it’s given resources, it gives rise to inflationary pressures in the economy. The aggregate demand may rise due to large increase in consumption demand by households or investment expenditure by entrepreneurs, or government expenditure.
•  In these circumstances inflationary gap occurs which tends to bring about rise in prices. Under such circumstances, a contractionary fiscal policy will have to be used.
• Contractionary fiscal policy refers to the deliberate policy of government applied to curtail aggregate demand and consequently the level of economic activity.

 In other words, it is fiscal policy aimed at eliminating an inflationary gap. This is achieved by adopting policy measures that would result in the aggregate demand curve (AD) shift the to the left so the equilibrium may be established at the full employment level of real GDP. This can be achieved either by:

1. Decrease in government spending: With decrease in government spending, the total amount of money available in the economy is reduced which in turn trim down the aggregate demand.

2. Increase in personal income taxes and/or business taxes: An increase in personal income taxes reduces disposable incomes leading to fall in consumption spending and aggregate demand. An increase in taxes on business profits reduces the surpluses available to businesses, and as a result, firms’ investments shrink causing aggregate demand to fall. Increased taxes also dampen the prospects of profits of potential entrants who will respond by holding back fresh investments.

3. A combination of decrease in government spending and increase in personal income taxes and/or business taxes

We shall analyze the overall impact of these abovementioned measures with the help of the following figure.

Contractionary Fiscal policy for Combating Inflation

As real GDP rises above its natural level, (Y in the above figure), prices also rise, prompting an increase in wages and other resource prices. This causes the SAS curve to shift from SAS 1 to SAS 2. As a result, the price level goes up from P 1 to P 3. Nevertheless, the real GDP remains the same at Y. The government now needs to intervene to control inflation by engaging in a contractionary fiscal policy designed to reduce aggregate demand so that the aggregate demand curve (AD1) does not shift to AD2 . The government needs to reduce expenditures or raise taxes only by a small amount because of the multiplier effects that such actions may have. Even as expenditures are reduced, the government may attempt to enhance public revenues in order to generate a budget surplus. In any economy, on account of political, social and defence considerations government spending cannot be reduced beyond a particular limit. However, the government can change its expenditure in response to inflationary pressures. 

FISCAL POLICY FOR LONG-RUN ECONOMIC GROWTH 

• We have been discussing so far about how fiscal policy acts as an effective tool for managing aggregate demand in the short-run to help maintain price stability and employment levels. However, demand-side policies unaccompanied by policies to stimulate aggregate supply cannot produce long-run economic growth.
•  Fiscal policies such as those involving infrastructure spending generally have positive supply-side effects. When government supports building a modern infrastructure, the private sector is provided with the requisite overheads it needs. Government provision of public goods such as education, research and development etc. provide momentum for long-run economic growth.
•  A well designed tax policy that rewards innovation and entrepreneurship, without discouraging incentives will promote private businesses who wish to invest and thereby help the economy grow.