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.
However, a shift of aggregate demand from AD 0 to AD 1 , enacted through an expansionary fiscal policy, can move the economy to a new equilibrium output of E 1 at the level of potential GDP. Since the economy was originally producing below potential GDP, any inflationary increase in the price level from P 0 to P 1 that results should be relatively small.
Should the government use tax cuts or spending increases, or a mix of the two, to carry out expansionary fiscal policy? After the Great Recession of —, U. This very large budget deficit was produced by a combination of automatic stabilizers and discretionary fiscal policy.
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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.
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