To What Extent Does Contractionary Policy Contribute To A Decline In Economic Activity?

1600 words - 6 pages

Fiscal policy is the government’s attempt to influence the economy by setting and changing taxes, government spending, and the government’s deficit and debt (Matthews et al 2003). Contractionary fiscal policy is, therefore, a policy where a decrease in government’s spending, an increase in taxes plus a decrease in transfer payments are applied to mitigate the inflationary issues that occur during a business cycle expansion. Thus, it restrains the economy, decreases the inflation rate and closes the inflation gap. This Essay will investigate the extent of the contribution of this policy to a decline in economic activity. Consequently, it will analyse the effects on economic activity under the Keynesian theory, the “classical” theory, and the Mundell-Fleming model. Furthermore, commentary on the results of an empirical study under a fixed exchange rate regime of the Obstfeld and Rogoff model will be provided and contrasted to other theories and models.
Contractionary fiscal policy, which is a reduction in the budget deficit, works through government spending and taxes. However, it is easier to separate them into three tools, namely, government purchases, taxes and transfer payments to see their effect on economic activity in the short run, medium run and long run. Government purchases are government expenditures, which are undertaken by government agencies, on final goods and services or gross domestic product in an economy. These include small items such as paper clips, office furniture, and teachers’ salaries to motorway construction. Hence, contractionary fiscal policy will involve a cut in funds appropriated to the various agents, thereby reducing aggregate production, income and inflation rates. Consequently, this policy is not easy to carry out as it is unpopular. Hence, governments are not keen to employ it due to its adverse short run results, which have political repercussions.
Policy makers tend to favour tinkering with taxes instead, which when being raised as in contractionary fiscal policy, are also unpalatable for governments. This mostly involves the raising of the income tax rate or a one time surcharge. An increase in taxes results in lower disposable income causing people to decrease their consumption. Furthermore, the decrease in consumption means a decrease in demand and a corresponding decrease in output and income. On an IS-LM curve, the effect is a shift upwards and to the left of the IS curve and a movement along the LM curve. Due to the reduced income there is less demand for money, resulting in a decrease in interest rates. Hence, it follows that, in the short run, a reduction in the budget deficit leads to reduced spending, accompanied by a contraction in output. However, in the medium run, output eventually returns to the natural level of output by adjustments through changes in the price level. This is dependent on the level of productivity (as a given) and the natural level of employment. Thus, the price level...

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