Contractionary Fiscal Policy and Its Purpose With Examples

​Somer G. Anderson is CPA, doctor of accounting, and an accounting and finance professor who has been working in the accounting and finance industries for more than 20 years. Her expertise covers a wide range of accounting, corporate finance, taxes, lending, and personal finance areas.

Contractionary fiscal policy is when the government either cuts spending or raises taxes. It gets its name from the way it contracts the economy. It reduces the amount of money available for businesses and consumers to spend.

Key Takeaways

• Contractionary fiscal policy is when elected officials either cut spending or increase taxes.
• It is disliked by voters who want to keep government benefits.
• The unpopularity of contractionary policy increases the budget deficit and national debt.

Purpose

The purpose of contractionary fiscal policy is to slow growth to a healthy economic level. That's between 2% to 3% a year. An economy that grows more than 3% creates four negative consequences.

1. It creates inflation. That's when prices rise too fast in clothing, food, and other necessities. Higher prices quickly gobble up savings and degrade the standard of living.
2. It drives up prices in investments. That's called an asset bubble. It's happened in stocks, gold, and oil. An example of its devastating effects is the 2006 housing bubble. By 2005, the cost of housing became unaffordable for most families. Banks lowered their terms to entice subprime borrowers, creating a crisis in 2008.
3. It's unsustainable. Growth at 4% or more leads to a recession. That especially occurs with asset bubbles. Unfortunately, a recession is part of the business cycle.
4. It lowers unemployment to below the natural rate of unemployment. Employers struggle to find enough workers to meet market demand. That slows growth from the production side.

When governments cut spending or increase taxes, it takes money out of consumers' hands. That also happens when the government cuts subsidies, transfer payments including welfare programs, contracts for public works, or the number of government employees.

Shrinking the money supply decreases demand. It gives consumers less purchasing power. That reduces business profit, forcing companies to cut employment.

Why Politicians Rarely Use It

Elected officials use contractionary fiscal policy much less often than expansionary policy. That's because voters don't like tax increases. They also protest any benefit decreases caused by reduced government spending. As a result, politicians who use contractionary policy are soon voted out of office.

The unpopularity of contractionary policy results in ever-increasing federal budget deficits. To make up for the deficit, the government just issues new Treasury bills, notes, and bonds.

These annual budget deficits worsen the U.S. debt. It's over $27 trillion, more than what the United States produces in a year. Over the long run, the debt-to-GDP ratio is unsustainable. In time, purchasers of U.S. Treasurys will worry that they won't get repaid. They will demand higher interest rates to compensate them for the added risk.

Higher rates will slow economic growth. The economy suffers the effects of contractionary monetary policy whether it wants to or not.

Note

State and local governments are more likely to use contractionary fiscal policies.

That's because they must follow balanced budget laws. They aren't allowed to spend more than they receive in taxes. That's a good policy, but the downside is it limits lawmakers' ability to recover during a recession. Unless they have a surplus when the recession hits, they must cut spending right when they need it most.

Examples

President Bill Clinton used contractionary policy by cutting spending in several key areas. First, he required welfare recipients to work within two years of getting benefits. After five years, benefits were cut off. He also raised the top income tax rate from 31% to 39.6%.

President Franklin D. Roosevelt used contractionary policy too soon after the Depression. He was reacting to political pressure to cut the debt. The Depression came roaring back in 1932. It didn't end until FDR geared up spending for World War II. That was a massive return to expansionary fiscal policy.

Contractionary Fiscal vs. Monetary Policy

Contractionary monetary policy occurs when a nation's central bank raises interest rates and decreases the money supply. It's done to prevent inflation. The long-term impact of inflation can be more damaging to the standard of living than a recession. Expansionary monetary policy boosts economic growth by lowering interest rates. It's effective in adding more liquidity in a recession.

The benefit of monetary policy is that it works faster than fiscal policy. The Federal Reserve votes to raise or lower rates at its regular Federal Open Market Committee meeting. It takes about six months for the added liquidity to work its way through the economy.

Frequently Asked Questions (FAQs)

How would contractionary fiscal policy affect a budget deficit?

All else equal, contractionary fiscal policy measures would reduce a budget deficit. Under certain circumstances, these measures could turn a deficit into a surplus. It depends on how much the measures reduce spending or raise revenue.

How does contractionary fiscal policy affect economic growth?

Contractionary fiscal policies typically slow economic growth. Reducing government spending slows an economy, as does increasing tax revenue. However, contractionary fiscal policy is typically used to slow an economy that is growing quickly. In theory, while the policies could slow the economy, they would only bring it to a healthy growth rate.