What is contractionary fiscal Policy?

Contractionary fiscal policy includes increasing taxes, decreasing spending or some of both. Contractionary fiscal policy decreases GDP by decreasing Government Purchases through decreases in government spending or decreasing Personal Consumption and Gross Investment through tax increases. These changes have a multiplier effect on the overall economy depending on the economy’s MPS.

Contractionary fiscal policy decreases the government deficit, but it is possible to have a contractionary effect on the economy without impacting the deficit by decreasing taxes and spending by the same amount. This is called the balanced budget multiplier.

How can lag times reduce or eliminate the effectiveness of fiscal policy?

One problem with fiscal policy being used to bring the economy back to long-run equilibrium to eliminate inflationary or recessionary gaps, is lag times. When the economy enters a recession, for example, it will take some time for Congress and the president to recognize the need for discretionary fiscal policy. Then, it will take time for policy changes to be developed and passed by Congress. Finally, it will take even more time for the policy to be implemented and take effect. All of these time lags (recognition, decision, implementation, and effectiveness) could mean that the recession is over by the time the fiscal policy impacts the economy and the policy could even cause an inflationary gap creating problems instead of solving them. 

What are automatic stabilizers?

An automatic stabilizer is any fiscal policy which automatically increases the deficit during a contraction and automatically decreases the deficit during a period of expansion. They essentially help limit the effects of the business cycle.

Income taxes are an automatic stabilizer since they automatically increase when the economy expands as citizens earn more money and are therefore taxed more. Income taxes also automatically decreases when the economy contracts. As a result, income taxes increase the deficit when the economy contracts and decrease the deficit when the economy expands.

Transfer payments such as unemployment, food stamps, and welfare payments are also automatic stabilizers because this government spending increases during recessions and decreases during expansions. They cause the deficit to increase during contractions and decrease during expansions and help limit business cycle severity.

What is the spending/tax multiplier?

An economy’s MPC and MPS have implications for the overall economy. Changes in taxes or government spending multiplies through the economy and has a larger impact on Gross Domestic Product (GDP). This spending could take the form of a new investment from businesses, new spending from consumers or the government, or new sales of exports. Any of this new spending would multiply through the economy.

Make sure you have a good handle on how the tax and spending multipliers work. You can learn more here: Propensities and Multipliers