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- The economy starts at the equilibrium quantity of output Yr, which is above potential GDP. The extremely high level of aggregate demand will generate inflationary increases in the price level. A contractionary fiscal policy can shift aggregate demand down from AD 0 to AD 1, leading to a new equilibrium output E 1, which occurs at potential GDP.
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A contractionary fiscal policy can shift aggregate demand down from AD 0 to AD 1, leading to a new equilibrium output E 1, which occurs at potential GDP. Again, the AD–AS model does not dictate how this contractionary fiscal policy is to be carried out.
- Learn By Doing: Expansionary and Contractionary Fiscal Policy
Module 11: Fiscal Policy. Search for: Learn By Doing:...
- Fiscal Policy | Macroeconomics – Haci - Lumen Learning
In this situation, contractionary fiscal policy involving...
- Learn By Doing: Expansionary and Contractionary Fiscal Policy
- Overview
- Lesson Summary
- Fiscal policy is used to achieve macroeconomic goals
- Government spending directly affects AD; taxes indirectly affect AD
- Choosing the correct amount
- The balanced budget multiplier always equals 1
- Lags can complicate fiscal policy in the real world
- Closing the output gap
- Key graphs
- Common misperceptions
In this lesson summary review and remind yourself of the key terms, calculations, and graphs related to fiscal policy. Topics include how taxes and spending can be used to close an output gap, how to model the effect of a change in taxes or spending using the AD-AS model, and how to calculate the amount of spending or tax change needed to close an output gap.
Lesson Summary
Consider a tale of two economies. Marthlandia has an economic boom which has been going on for awhile. But as a result, Marthlandia struggles with high inflation.
Burginville, on the other hand, has been in a recession for quite some time, with high unemployment causing widespread suffering. But the self-correction mechanism isn't kicking in for either country. Is there anything that can be done?
Yes! Both governments can use fiscal policy as a tool to bring their countries back to “normal.” For example, they can use fiscal policy (changes in government spending or taxes), which will impact output, unemployment, and inflation.
Burginville needs to increase output to end its recession. Their government can increase output by using expansionary fiscal policy. Expansionary fiscal policy tools include increasing government spending, decreasing taxes, or increasing government transfers. Doing any of these things will increase aggregate demand, leading to a higher output, higher employment, and a higher price level.
Consider a tale of two economies. Marthlandia has an economic boom which has been going on for awhile. But as a result, Marthlandia struggles with high inflation.
Burginville, on the other hand, has been in a recession for quite some time, with high unemployment causing widespread suffering. But the self-correction mechanism isn't kicking in for either country. Is there anything that can be done?
Yes! Both governments can use fiscal policy as a tool to bring their countries back to “normal.” For example, they can use fiscal policy (changes in government spending or taxes), which will impact output, unemployment, and inflation.
Burginville needs to increase output to end its recession. Their government can increase output by using expansionary fiscal policy. Expansionary fiscal policy tools include increasing government spending, decreasing taxes, or increasing government transfers. Doing any of these things will increase aggregate demand, leading to a higher output, higher employment, and a higher price level.
Marthlandia’s inflation is caused by producing more than is sustainable, so reducing output would fix its problem. Instead, they can draw on contractionary fiscal policy tools, such as increasing taxes or decreasing government spending or government transfers.
Doing any of these things will decrease Marthlandia’s aggregate demand, which leads to lower output, lower employment, and a lower price level. Usually, governments engage in expansionary fiscal policy during recessions, and contractionary fiscal policy when they are concerned about inflation.
Imagine a government wants to fix a recession or dial back an expansion. Its concrete goals would be to return the economy to full employment, or to control inflation, respectively. Fiscal policy can help them achieve their goals.
The tools of fiscal policy are government spending and taxes (or transfers, which are like “negative taxes”). You want to expand an economy that is producing too little, so expansionary fiscal policy is used to close negative output gaps (recessions). Expansionary fiscal policy includes either increasing government spending or decreasing taxes.
An economy that is producing too much needs to be contracted. In that case, contractionary fiscal policy (either decreasing government spending or increasing taxes) is the correct choice.
For example, if Burginville is experiencing a recession, the government might give everyone a tax refund (an example of expansionary fiscal policy). Here’s what will play out: the tax refund leads to an increase in disposable income An increase in disposable income causes an increase in consumption, the increase in consumption increases aggregate demand An increase in aggregate demand leads to an increase in output and a decrease in unemployment As a side effect of the decrease in unemployment and the increase in output, inflation will increase.
How are the effects of government spending and taxes different? When a government engages in fiscal policy using government spending, the effect is immediate because government spending is itself a component of AD. For example, if the government buys 600 pounds of rice for $1000 from a farmer in Burginville, that $1000 counted in the G component of AD and real GDP, and then the spending multiplier kicks in.
But when a government engages in fiscal policy by using taxes or transfers, the impact is indirect. If the government of Burginville gives that farmer a $1000 tax refund instead of buying something from him directly, the impact of that action won't have any effect until the farmer actually does something with that refund. In fact, if he puts all of that refund under his mattress, there would be no impact at all!
But, if the farmer saves $200 and spends the rest on airline tickets to Florida, the $800 is counted in consumption spending. The purchase of the plane ticket then triggers the multiplier effect.
Remember: the tax multiplier is always less than the spending multiplier because some of that amount is saved, and not spent, in the first step.
When a gap is negative, you want output to get bigger, and so expansionary fiscal policy the right choice. When a gap is positive, you want output to get smaller, and so contractionary fiscal policy is the right choice. Once you decide on the type of policy (expansionary or contractionary), you can then decide on which tool to use (taxes or spending).
Policymakers also have to be careful to "mind the gap." If they want to close an output gap, they need to know how much stimulus is necessary. Too little stimulus and you won't close the gap. Too much stimulus and you may cause a different kind of gap.
For example, suppose that the economy of Burginville has an output gap of $20 billion. They need to take a policy action that causes exactly the amount of change. The good news is that they don't actually have to spend $20 billion to close that gap. Why? Because they can count on multipliers.
Recall that the spending multiplier gave us the final impact on AD of an increase in any category of spending. If the spending multiplier is 4, then an increase in government spending of $20 billion would increase real GDP by 4x$20=$80 billion.
A government has a balanced budget when its expenditures are equal to its revenues. In other words, if a government wants to spend $20 , but it also wants to maintain a balanced budget, then it needs to take in $20 in taxes. Governments run deficits when spending is higher than tax revenue, and they run surpluses when spending is lower than tax revenue. Over time, those deficits accumulate into national debt.
What if a government wants to use expansionary fiscal policy, but it also wants to maintain a balanced budget? If Burginvlle is in a recession and has a $100 million negative output gap, it needs to use expansionary fiscal policy to close that gap. Because it has a spending multiplier of 10 , it decides to increase government spending by $10 million to close that gap:
10×$10 million=$100 million .
However, to maintain a balanced budget, it also raises taxes by $10 million. But wait . . . that will have its own multiplier effect! Remember that the tax multiplier is always one less than the spending multiplier, and negative. Therefore, if the spending multiplier is 10 , the tax multiplier is −9 . The impact of the tax increase will be:
−9×$10 million=$−90 million .
To find the final impact of these actions, we add them together:
In reality, four things can slow down a fiscal policy’s implementation and e effectiveness:
1.Data lag
This is the time to collect information about the economic conditions in a country. Suppose there is some shock to an economy, such as a decline in consumer confidence. A policymaker might not notice this until data on real GDP and unemployment rate are collected.
1.Recognition lag
This is the time it takes to realize there might be a problem. The policy-maker gets handed a report from their intern that says unemployment is up and real GDP is down. But is this a temporary thing? Or is the start of a long-run trend? If it is temporary, there isn't any need to take any action. If it is a long-run trend, that trend has already started by the time it is recognized.
1.Decision lag
To determine the size of a policy action needed (such as how much government spending or how much taxes will need to change), you divide the size of the gap by the relevant multiplier.
size of tax cut needed=size of gaptax multipliersize of government spending needed=size of gapspending multiplier
We can show the impact of fiscal policy on output and the price level using the AD-AS model.
Figure 1 shows an economy that has an initial AD curve of AD1 and is producing real GDP worth $130 billion. However, the full employment output for this economy is $100 billion (we can tell this because the LRAS curve is always vertical at the full employment output). Positive output gaps like this one are usually associated with higher inflation, so the government decides to take action in order to bring inflation under control.
The government knows that its MPC=0.75 , so its tax multiplier is −3 . If the government engages in contractionary fiscal policy by increasing taxes by $10 billion, then the final impact of that increase will be
−3×$10 billion=−$30 billion
•When first learning about stabilization policies, some people think that the objective of stabilization policies is to eliminate the business cycle. But that is not the case. The objective of stabilization policy is not to “fine-tune” the economy. The goal of stabilization isn’t to make the business cycle go away completely, but to make the ups and downs less dramatic. In other words, we don’t want to make the business cycle a flat line, just less “bumpy”.
•Some people mistakenly assume that fiscal policy (or any kind of discretionary policy) is as easy as some simple calculations. Unfortunately, that isn’t very realistic. Lags make active stabilization policy tricky. For one, the self-correction mechanism may be working in the background, so by the time a policy is finally implemented, it might not be the correct action anymore. Another problem is they make it longer before a corrective action kicks in. One potential solution is to have some form of passive, or automatic, stabilizers that will kick in automatically when a problem arises. We learn more about those in the next lesson.
•Some learners confuse two important types of stabilization policy: fiscal policy and monetary policy. Fiscal policy is the domain of governments. Monetary policy is the domain of central banks (which are usually independent of government budgetary actions).
•Another common misperception is that if government spending increases by the same amount as a tax increase, they completely cancel each other out. A $100 million increase in government spending that is paid for by increasing taxes by $100 million won’t completely cancel each other out. The balanced budget multiplier is equal to one, not zero. When there is a balanced budget, the final impact on real GDP is a $100 million increase as a result of the balanced budget multiplier.
•When first learning about discretionary stabilization policies, it can be tricky to remember what specific actions are expansionary and what are contractionary. The table below can be your guide:
Discussion questions
Jan 20, 2022 · Contractionary fiscal policy is when elected officials either cut spending or increase taxes. It is disliked by voters who want to keep government benefits. The unpopularity of contractionary policy increases the budget deficit and national debt.
- Kimberly Amadeo
A contractionary fiscal policy can shift aggregate demand down from AD 0 to AD 1, leading to a new equilibrium output E 1, which occurs at potential GDP, where AD1 intersects the LRAS curve. Again, the AD–AS model does not dictate how the government should carry out this contractionary fiscal policy.
Fiscal policy—the use of government expenditures and taxes to influence the level of economic activity—is the government counterpart to monetary policy. Like monetary policy, it can be used in an effort to close a recessionary or an inflationary gap. Some tax and expenditure programs change automatically with the level of economic activity.
A contractionary fiscal policy can shift aggregate demand down from AD 0 to AD 1, leading to a new equilibrium output E 1, which occurs at potential GDP, where AD1 intersects the LRAS curve. Again, the AD–AS model does not dictate how the government should carry out this contractionary fiscal policy.
