Contractionary policy is a monetary measure referring either to a reduction in government spending—particularly deficit spending—or a reduction in the rate of monetary expansion by a central bank.
It is a type of macroeconomic tool designed to combat rising inflation or other economic distortions created by central banks or government interventions. Contractionary policy is the polar opposite of expansionary policy.
Contractionary policies aim to hinder potential distortions to the capital markets. Distortions include high inflation from an expanding money supply , unreasonable asset prices, or crowding-out effects, where a spike in interest rates leads to a reduction in private investment spending such that it dampens the initial increase of total investment spending.
While the initial effect of the contractionary policy is to reduce nominal gross domestic product GDP , which is defined as the gross domestic product GDP evaluated at current market prices , it often ultimately results in sustainable economic growth and smoother business cycles. Contractionary policy notably occurred in the early s when the then-Federal Reserve chair Paul Volcker finally ended the soaring inflation of the s.
Governments engage in contractionary fiscal policy by raising taxes or reducing government spending. In their crudest form, these policies siphon money from the private economy, with hopes of slowing down unsustainable production or lowering asset prices. In modern times, an increase in the tax level is rarely seen as a viable contractionary measure. Instead, most contractionary fiscal policies unwind previous fiscal expansion, by reducing government expenditures—and even then, only in targeted sectors.
If contractionary policy reduces the level of crowding out in the private markets, it may create a stimulating effect by growing the private or non-governmental portion of the economy. This bore true during the Forgotten Depression of to and during the period directly following the end of World War II when leaps in economic growth followed massive cuts in government spending and rising interest rates.
Contractionary policy is often connected to monetary policy, with central banks such as the U. Federal Reserve, able to enact the policy by raising interest rates. 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. In short, the figure shows an economy that is growing steadily year to year, producing at its potential GDP each year, with only small inflationary increases in the price level.
Figure 1. A Healthy, Growing Economy. In this well-functioning economy, each year aggregate supply and aggregate demand shift to the right so that the economy proceeds from equilibrium E 0 to E 1 to E 2. Each year, the economy produces at potential GDP with only a small inflationary increase in the price level.
But if aggregate demand does not smoothly shift to the right and match increases in aggregate supply, growth with deflation can develop.
In the real world, however, aggregate demand and aggregate supply do not always move neatly together, especially over short periods of time. Aggregate demand may fail to grow as fast as aggregate supply, or it may even decline causing a recession. This could be caused by a number of possible reasons: households become hesitant about consuming; firms decide against investing as much; or perhaps the demand from other countries for exports diminishes.
For example, investment by private firms in physical capital in the U. Conversely, increases in aggregate demand could run ahead of increases in aggregate supply, causing inflationary increases in the price level. Business cycles of recession and boom are the consequence of shifts in aggregate supply and aggregate demand.
As these occur, the government may choose to use fiscal policy to address the difference. Expansionary fiscal policy increases the level of aggregate demand, through either increases in government spending or reductions in taxes.
Expansionary policy can do this by:. Contractionary fiscal policy does the reverse: it decreases the level of aggregate demand by decreasing consumption, decreasing investments, and decreasing government spending, either through cuts in government spending or increases in taxes. Consider first the situation in Figure 2, which is similar to the U. At the equilibrium E 0 , a recession occurs and unemployment rises.
The figure uses the upward-sloping AS curve associated with a Keynesian economic approach, rather than the vertical AS curve associated with a neoclassical approach, because our focus is on macroeconomic policy over the short-run business cycle rather than over the long run.
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. 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. Expansionary fiscal policy increases the level of aggregate demand, either through increases in government spending or through reductions in taxes.
Expansionary fiscal policy is most appropriate when an economy is in recession and producing below its potential GDP. Contractionary fiscal policy decreases the level of aggregate demand, either through cuts in government spending or increases in taxes.
Contractionary fiscal policy is most appropriate when an economy is producing above its potential GDP. What is the main reason for employing contractionary fiscal policy in a time of strong economic growth? What is the main reason for employing expansionary fiscal policy during a recession?
What is the difference between expansionary fiscal policy and contractionary fiscal policy? Under what general macroeconomic circumstances might a government use expansionary fiscal policy? When might it use contractionary fiscal policy? Is expansionary fiscal policy more attractive to politicians who believe in larger government or to politicians who believe in smaller government? Explain your answer.
Specify whether expansionary or contractionary fiscal policy would seem to be most appropriate in response to each of the situations below and sketch a diagram using aggregate demand and aggregate supply curves to illustrate your answer:. Alesina, Alberto, and Francesco Giavazzi. Chicago: University Of Chicago Press,
0コメント