Contractionary Fiscal Policy

A contractionary policy is a monetary measure to reduce government spending or the rate of monetary expansion by a central bank. It is a macroeconomic tool used to combat rising inflation.

The main contractionary policies employed by the United States government include raising interest rates, increasing bank reserve requirements, and selling government securities.

Contractionary policies aim to hinder potential distortions to the capital markets. Distortions include high inflation from an expanding money supply, unreasonable asset prices, or crowding-out effects, where a spike in interest rates leads to a reduction in private investment spending such that it dampens the initial increase of total investment spending.

While the initial effect of the contractionary policy is to reduce nominal gross domestic product (GDP), which is defined as the gross domestic product (GDP) evaluated at current market prices, it often ultimately results in sustainable economic growth and smoother business cycles.

Contractionary policy notably occurred in the early 1980s when the then-Federal Reserve chair Paul Volcker finally ended the soaring inflation of the 1970s. At their peak in 1981, target federal fund interest rates neared 20 per cent. Measured inflation levels declined from nearly 14 per cent in 1980 to 3.2 per cent in 1983.

Increasing taxes reduces the money supply and decreases the purchasing power of consumers. It may also slow down unsustainable production or lower the value of assets.

Reducing government spending in areas such as subsidies, welfare programs, contracts for public works, or the number of government employees.

The COVID-19 pandemic affected businesses’ ability to produce and consumers’ ability to consume. Many governments resorted to large fiscal stimuli which boosted consumption leading to supply chain bottlenecks and price tensions.

The government support throughout the crisis supported a strong economic rebound, with both GDP and employment recovering at a remarkable pace through 2021.

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