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Contractionary Fiscal Policy and Aggregate Demand

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  1. 1:24 Expansionary Gaps
  2. 2:28 Overheating Economy
  3. 3:38 Fiscal Authorities
  4. 6:29 Three Tools of CFP
  5. 8:04 Illustrating CFP
  6. 10:21 Lesson Summary
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Taught by

Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

This lesson examines how fiscal authorities use contractionary fiscal policy to slow down the economy and defeat the enemy called inflation. Find out what fiscal tools the federal authorities can use to contract the economy.

An Economy Overheating with Inflation

Meet Jennifer. Jennifer currently earns a $2,000 paycheck each month by working at an ice cream stand. Jennifer's $2,000 has a certain amount of purchasing power, meaning that she can buy a certain amount of goods and services with it. She typically spends her $2,000 paycheck buying clothes and food.

Now the economy begins to grow rapidly. Jennifer notices it because the lines have grown at the ice cream stand. The next thing she knows, her paycheck has gone up from $2,000 to $2,500 - a nice raise. Unfortunately, the enemy called inflation also begins to show up.

Economists call this scenario an expansionary gap. In this lesson, we'll find out more about what it is, how it's illustrated, and, more importantly, how the government responds to an economy that is overheating with inflation using what they call 'contractionary fiscal policy.'

The Effects of an Expansionary Gap

Jennifer is experiencing the effects of an inflationary economy as they happen and eventually realizes why there may be a need for help from the government. When Jennifer first receives the extra $500 from her raise, she's extremely excited about being able to buy $500 of additional goods and services. As a matter of fact, she's thinking about buying several stylish skirts and three pairs of designer jeans.

Well, her excitement turns to discouragement and disappointment the next time she does her regular grocery shopping and pays her bills for the month. Although her paycheck increased, so have all the prices for goods and services in the economy. They've increased for the same reason her ice cream prices did - the economy is overheating with inflation, which steals the purchasing power of the money.

How Economists Illustrate an Overheating Economy

Graph illustrating an expansionary gap, also called an inflationary gap
Expansionary Gap Illustration

As you can see, point A is where the economy is right now. Notice that it's to the right of the vertical line, which is the long-run aggregate supply curve. This vertical line represents the economy's potential - or capacity, if you want to think of it that way - so that means an expansionary gap is when the economy is growing faster than its potential. Like a long-distance runner who temporarily runs faster than his or her capacity and starts to burn out, the economy begins to overheat when it grows above its capacity.

Fiscal Authorities Prepare to Respond

Once Jennifer discovers that the economy is overheating with inflation, she goes back to her ice cream stand and presses a secret button that sends an immediate signal to the Capitol building in Washington, D.C., where government leaders are alerted to a major threat. Government leaders, otherwise known as 'fiscal authorities' - that's what we call them in economics - leave their meetings and run to the fiscal policy room to decide on a course of action.

Here's how economists look at the situation. The word 'fiscal' refers to the government's budget, which includes government spending, taxes and transfer payments like welfare or social security. Fiscal authorities use contractionary fiscal policy to slow down the economy, which offsets - or reverses - an inflation problem. Contractionary fiscal policy is the use of government spending, taxation and transfer payments to contract economic output.

Think of it this way: when a long-distance runner starts to overheat, he slows down and cools off. His heart rate comes back down to a more normal level. His body comes back into balance. Likewise, when the economy is overheating with inflation, it needs to slow down and cool off. Inflation needs to come back to a more normal level. Supply and demand need to come back into balance. The government sometimes steps in to help it slow down by using contractionary fiscal policy, which is what we're talking about in this lesson.

Fiscal Policy: Keynesian vs. Classical Viewpoint

Contractionary fiscal policy is a Keynesian thing, because famous economist John Maynard Keynes first proposed it after living through and observing the Great Depression. He believed that the government should step in and help, when necessary, to cool down an economy that is overheating with inflation. On the other hand, there are classical economists. Classical economists favor doing absolutely nothing to help the economy because they believe that the self-correcting forces of the free market will fix high inflation on its own.

Three Tools of Contractionary Fiscal Policy

There are three tools the government uses to contract the economy. Here are the tools and how they're used. They can:

  • Decrease government spending
  • Increase taxes
  • Decrease transfer payments

Suppose that inflation goes from a three percent rate to a ten percent annual rate, which is what Jennifer observed at the ice cream stand and at her favorite clothing store. Let's say that at the same time, real GDP goes from two percent to ten percent. So the economy is growing rapidly, but prices are also going up. How would the government respond to this situation? The appropriate contractionary fiscal policy, in this case, would be to raise taxes and decrease government spending. They could also decrease transfer payments, although this option is rarely used because it's so politically unpopular to reduce the benefits that voters are receiving from the government. What do you think people would do if they said, 'Okay, we're going to lower welfare payments, lower social security payments, etc.?' People would be very upset, so this option is not used very often.

Illustrating Contractionary Fiscal Policy

Graph illustrating contractionary fiscal policy in action
Contractionary Fiscal Policy Graph

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