Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Contractionary fiscal policy


Contractionary fiscal policy is a decrease in government expenditure or an increase in taxation. Either of these policy changes affects the economy by decreasing aggregate demand.

Government expenditure (G) is part of aggregate demand (AD = C + I + G + NX), so any decrease in G directly leads to a decrease in AD. An increase in taxes also impacts on AD through two main mechanisms: increased taxes reduce consumption due to the reduction in disposable income. Equally, increased tax rates can reduce investment, because firms keep less of the fruits of their investment.

Automatic stabilisers


Automatic stabilisers, as their name suggests, act to stabilise the economy by bringing output back towards its natural level. Furthermore, this process happens automatically, that is, without any change in fiscal policy by policy makers.

To see how this works, consider that output is higher than its natural level – for example, after a positive AD shock. Higher output (in the short run) means that people are earning more income and firms are making more profits, which will automatically increase the amount of tax that the government collects. This puts the brakes on the economy – in much the same way as would contractionary fiscal policy; however, the big difference is that it happens automatically. Policy makers don’t actually have to do anything, the taxes just pour in!

The stabilisation process works in the other direction too. Consider the case where output is less than its natural level, perhaps due to a negative AD shock. This situation leads to a fall in output and an increase in unemployment. But it also reduces the amount of tax revenue that the government collects. This automatically boosts the economy, much like expansionary fiscal policy would boost the economy, except that, very conveniently, it happens automatically!

In both cases aggregate demand falls, as you can see in Figure 9-7. Contractionary fiscal policy has caused aggregate demand to fall from AD₁ to AD₂. In the short run, sticky prices caused a fall in output and a relatively modest fall in prices. The fall in output also means that in the short run
unemployment increases beyond its natural rate.


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Figure 9-7: Contractionary fiscal policy.

In the long run, however, prices become flexible, causing the short-run aggregate supply to shift from SRAS₁ to SRAS₂. The price level falls more substantially and output increases back to its natural level. Similarly, unemployment falls back to its natural rate.

Thus contractionary fiscal policy can be painful in the short run because it reduces living standards and increases unemployment. But if the government is patient and waits for the price level to adjust, output increases back up to its old level.

In a similar way to expansionary fiscal policy (see the preceding section), contractionary fiscal policy can also potentially impact the supply side of the economy. In particular, falls in important areas of expenditure, such as education and health, can reduce the productivity of workers and reduce the natural level of output. Equally, higher taxes can cause investment to fall, which can mean that the new capital goods aren’t enough to cover the depreciation of the existing capital stock. The result is also to cause LRAS to shift to the left and reduce the natural level of output. For more on supply-side shocks, read the later section ‘Bumping into Supply-Side Shocks’.