Contractionary Fiscal Policy
What is Contractionary Fiscal Policy?
Contractionary fiscal policy is a decrease in government spending or an increase in taxes used to reduce aggregate demand and fight inflation.
It shifts aggregate demand left, lowering the price level and real GDP and moving the budget toward surplus. It is used to close an inflationary gap. Political resistance often makes spending cuts and tax increases hard to enact.
Contractionary Fiscal Policy: a worked example
An economy produces real GDP of $930 billion while full employment output is $900 billion, so an inflationary gap of $30 billion is open and the price index has been climbing. The marginal propensity to consume is 0.6, which makes the spending multiplier 1 divided by 0.4, or 2.5, and the tax multiplier negative 0.6 divided by 0.4, or negative 1.5. Route one: cut government purchases by $30 billion divided by 2.5, which is $12 billion. Route two: raise taxes by $30 billion divided by 1.5, which is $20 billion. The tax route always needs the larger dollar change, because households meet part of a tax increase by saving less and therefore cut spending by less than the full amount. Either move shifts aggregate demand left by $30 billion, returns output to $900 billion, eases the price index down, and pushes the budget balance toward surplus.
The mistake students make with contractionary fiscal policy
Asked to name a contractionary fiscal policy, students answer that the central bank raises interest rates or sells bonds. Both policies share the goal of fighting inflation, which hides the swap. Fiscal policy is set by the legislature and treasury, so open market operations, the discount rate, and reserve requirements earn nothing on a fiscal prompt no matter how well they are explained. A second slip is graphical: students correctly choose to cut purchases and then draw aggregate demand shifting right.
Contractionary Fiscal Policy questions
When should a government use contractionary fiscal policy?
Contractionary fiscal policy fits an economy producing beyond full employment output, where an inflationary gap is pushing the price level up and unemployment sits below its natural rate. Pulling aggregate demand back closes the gap and slows inflation. Using it during a recession would be a mistake, since it deepens the output loss. Lags matter as well, because a gap can close on its own before the legislation takes effect, leaving the policy to bite at the wrong moment.
What are the tools of contractionary fiscal policy?
Cutting government purchases, cutting transfer payments, and raising taxes are the three levers. Each pulls aggregate demand left, though not by the same amount per dollar: purchases work through the full spending multiplier, while tax increases and transfer cuts work through the smaller multiplier that applies to disposable income. A government can combine them, and any mix that shifts aggregate demand left by the size of the inflationary gap does the job.
What happens to the budget balance under contractionary fiscal policy?
The budget moves toward surplus, since spending falls or revenue rises by design. A government running a $70 billion deficit that cuts purchases by $12 billion moves to a $58 billion deficit before any feedback. Because the policy also lowers real GDP, tax collections slip through the automatic stabilizers, so the final improvement in the balance is somewhat smaller than the $12 billion cut. Sustained contraction can carry the budget all the way to surplus and begin shrinking the debt.
This is the live Fiscal Policy sandbox. Drag the curves, or open the full version.
Related terms
Common comparisons
Get AP Econ exam tips in your inbox
Occasional emails with study tips, new interactive graphs, and exam-season reminders. Free, no spam.
No spam. Unsubscribe anytime. Read our privacy policy.
Keep track of what you have studied
A free EconLearn account adds progress tracking, your quiz history, and achievements. Studying here is free either way, and there is nothing to pay for as a student.
Create a free accountAlready have one? Sign in
Last updated