Expansionary and Contractionary Fiscal Policy
Firstly, it is crucial to understand what a fiscal policy is. It is a monetary tool utilized by the government in order to influence the aggregate demand of the economy and therefore, the total output produced by the economy. Government incorporates its own budget to do this. It modifies its government spending (amount executed to produce public goods, unemployment advantages.) and the rate of taxes it imposes.
There are two primary policy tools that federal governments have in disposition to control their economies, both in the short-term and long-run: spending and taxation. These two tools are collectively called “fiscal policy.”
Expansionary Fiscal Policy
An expansionary fiscal policy is one that induces increase in aggregate demand. This is accomplished by the government via an increase in government spending and a reduction in taxes. These two motivate consumption as they elevate people's purchasing power. This can also be observed graphically as a rightwards shift of the aggregate demand (AD) curve that results in an increase in the equilibrium output of the economy and thus, an increase in GDP.
Contractionary Fiscal Policy
A contractionary fiscal policy is however the opposite. The government reduces government spending and elevates taxes. This significantly induces consumption to fall as purchasing power slumps. This can be displayed as a shift to the left of the AD curve, decreasing the equilibrium output of the economy and therefore, reducing GDP. Depending on the country's needs, the government will apply each policy.
Difference Between the Contractionary and Expansionary Fiscal Policy
Fiscal policy, or a government’s method of persuading the economy, consists of two opposing forms: contractionary fiscal policy and expansionary fiscal policy. Following are the differences between the two:-
Purpose of Contractionary Fiscal Policy
Contractionary Policy is Implemented in Times of Economic Affluence Because It:
Slows Inflation: During high economic growth, inflation can commonly spring up to dangerous rates, rapidly devaluing currency and panicking consumers. In order to slow inflation, governments may enact contractionary fiscal policy in order to decline the aggregate demand and money supply, which will result in reduced output and lower price levels.
Paces Economic Growth: While economic growth is an indicator of a healthy economy, an ideal growth is slow and steady—if, on contrary, economic growth spikes too severely, it can imply that a recession will follow for the purpose to compensate. To guarantee a slow, steady pace through the business cycle, governments can enact contractionary fiscal policy in order to maintain the AD curve, decrease citizens’ disposable income, and continue a healthy economic growth rate at 3%.
Reduces Government Debt: When the economy is flourishing, governments may make use of contractionary fiscal policy for the purpose of decreasing the government’s budget deficit and the national debt, saving up money for the future when expansionary policy may be necessary.
Keeps Unemployment at Optimal Levels: Lowering the unemployment rate may appear a critical issue for governments, but zero unemployment can really have a negative impact on the economy. A concept called the natural level of unemployment—the level in which an economy is ideally at equilibrium between laborers and employers—implies that there will always be some degree of unemployment, if or not the economy is performing well. If unemployment dips below the natural level of unemployment, businesses begin to struggle to find employees—and the economy starts to suffer. Contractionary fiscal policy stops the rate of unemployment from going down the optimal levels, maintaining it at what economists call “full employment,” which is when unemployment touches its lowest point without inducing inflation.
Example of Contractionary Fiscal Policy
Difference between contractionary and expansionary fiscal policy must be clear to you, now we will look into the examples of expansionary and contractionary fiscal policy.
While expansionary fiscal policy is particularly popular among voters since it indicates tax cuts or increased opportunities for government money, contractionary fiscal policy is substantially less popular because of its tax increases or cutting of government purchases, and many policymakers avert from it.
In the US, the most recent large-scale execution of contractionary fiscal policy appeared during President Bill Clinton’s time in office (1993–2001), when he heightened taxes on high-income taxpayers and slumped government spending on both defense and welfare. As an outcome, the US government went from being in debt to having a budget surplus.
FAQs on Difference Between Contractionary and Expansionary Fiscal Policy
1. What is Fiscal Policy?
Answer: A Fiscal policy is any financial policy executed by a national government, either by changing spending or taxation. There are two kinds of fiscal policy: Contractionary fiscal policy and expansionary fiscal policy. Expansionary fiscal policy is when the national government spends more than it taxes, on the other hand Contractionary fiscal policy is when the government taxes more than it spends.
Fiscal policy goes arm-in-arm with monetary policy, which is financial influence executed by a central bank (in the US, the central bank is the Federal Reserve)—generally in a way of increasing or decreasing interest rates.
2. What is Contractionary Fiscal Policy?
Answer: Contractionary fiscal policy is that kind of fiscal policy in which the government gathers more money than it spends in tax revenue —these types of policies are generally utilized during times of economic prosperity. In order to enact contractionary fiscal policy, the government may reduce spending, increase taxes, and enact a mix of decreased spending and increased taxation.
