Contractionary Fiscal Policy

by Obaidullah Jan, ACA, CFA

Contractionary fiscal policy is a form of fiscal policy that involves increasing taxes, decreasing government expenditures or both in order to fight inflationary pressures.

Due to an increase in taxes, households have less disposal income to spend. Lower disposal income decreases consumption. An increase in taxes also reduces profits available to businesses and they cut down their investment expenditures. Consumption and private investment are part of GDP, so GDP falls as a result. However, this fall is magnified by the multiplier effect.

A decrease in government expenditures decreases GDP directly because government expenditures is a part of GDP (i.e. GDP = consumption + private investment + government expenditures + net exports). But, such a decrease is worsened as a result of indirect decrease in consumption and other components of GDP.


Let us reuse the example from the article on expansionary fiscal policy.

Abigail Noble is an economist assisting the IMF in developing policy recommendations for different economies. Currently she is meeting with finance ministers of newly formed states of Sacramento and Salamia. Sacramento has inflation rate of 7% as compared to historical average of 3%, unemployment rate of 2% as compared with natural unemployment rate of 4%, budget deficit of 5% and a GDP growth rate of 6% as compared with average growth rate of 3%. Salamia on the other hand has 1% inflation, 8% unemployment as compared to historical average of 4%, budget surplus of 4% and GDP growth rate of 1.5%. For which country Abigail would most likely recommend contractionary fiscal policy?

High inflation, low unemployment rate (relative to natural rate of unemployment), a budget deficit and high growth rate indicates that Sacramento is facing inflationary pressures which makes contractionary fiscal policy appropriate. Sacramento can achieve this by either increasing taxes, decreasing its government expenditures or both. This will reduce the budget deficit, decrease growth rate, decrease inflation and increase unemployment rate. Salamia on the other hand, is facing recessionary pressures and contractionary fiscal policy will only worsen her problems.