Contractionary Fiscal Policy

Fiscal policy

Fiscal policy, taking the scope of budgetary policy, refers to government policy that attempts to influence the direction of the economy through changes in government taxes, or through some spending (fiscal allowances).

Fiscal policy can be contrasted with the other main type of macroeconomic policy, monetary policy, which attempts to stabilize the economy by controlling interest rates and the supply of money. The two main instruments of fiscal policy are government spending and taxation. Changes in the level and composition of taxation and government spending can impact on the following variables in the economy:

  • Aggregate demand and the level of economic activity
  • The pattern of resource allocation
  • The distribution of income.

Fiscal policy

Fiscal policy refers to the overall effect of the budget outcome on economic activity. The three possible stances of fiscal policy are neutral, expansionary and contractionary:

  • A neutral stance of fiscal policy implies a balanced budget where G = T (Government spending = Tax revenue). Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.
  • An expansionary stance of fiscal policy involves a net increase in government spending (G > T) through a rise in government spending or a fall in taxation revenue or a combination of the two. This will lead to a larger budget deficit or a smaller budget surplus than the government previously had, or a deficit if the government previously had a balanced budget. Expansionary fiscal policy is usually associated with a budget deficit.
  • Contractionary fiscal policy (G < T) occurs when net government spending is reduced either through higher taxation revenue or reduced government spending or a combination of the two. This would lead to a lower budget deficit or a larger surplus than the government previously had, or a surplus if the government previously had a balanced budget. Contractionary fiscal policy is usually associated with a surplus.

Methods of funding

Governments spend money on a wide variety of things, from the military and police to services like education and healthcare, as well as transfer payments such as welfare benefits.

This expenditure can be funded in a number of different ways:

Funding the deficit

A fiscal deficit is often funded by issuing bonds, like treasury bills or consols. These pay interest, either for a fixed period or indefinitely. If the interest and capital repayments are too large, a nation may default on its debts, usually to foreign creditors.

Consuming the surplus

A fiscal surplus is often saved for future use, and may be invested in local (same currency) financial instruments, until needed. When income from taxation or other sources falls, as during an economic slump, reserves allow spending to continue at the same rate, without incurring a deficit. Hong Kong ran a fiscal surplus of HK$123.6 billion in fiscal year 2007/08 (ended March 31, 2008), equal to US$15.85 billion or 7.7% of 2007 GDP.

Economic effects of fiscal policy

Fiscal policy is used by governments to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of price stability, full employment and economic growth. Keynesian economics suggests that adjusting government spending and tax rates are the best ways to stimulate aggregate demand. This can be used in times of recession or low economic activity as an essential tool in providing the framework for strong economic growth and working toward full employment. The government can implement these deficit-spending policies due to its size and prestige and stimulate trade. In theory, these deficits would be paid for by an expanded economy during the boom that would follow; this was the reasoning behind the New Deal.

During periods of high economic growth, a budget surplus can be used to decrease activity in the economy. A budget surplus will be implemented in the economy if inflation is high, in order to achieve the objective of price stability. The removal of funds from the economy will, by Keynesian theory, reduce levels of aggregate demand in the economy and contract it, bringing about price stability.

Despite the importance of fiscal policy, a paradox exists. In the case of a government running a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing or the printing of new money. When governments fund a deficit with the release of government bonds, an increase in interest rates across the market can occur. This is because government borrowing creates higher demand for credit in the financial markets, causing a lower aggregate demand (AD) due to the lack of disposable income, contrary to the objective of a budget deficit. This concept is called crowding out. Alternatively, governments may increase government spending by funding major construction projects. This can also cause crowding out because of the lost opportunity for a private investor to undertake the same project. Another problem is the time lag between the implementation of the policy and detectable effects in the economy. An expansionary fiscal policy (decreased taxes or increased government spending) is usually intended to produce an increase in aggregate demand; however, an unchecked spiral in aggregate demand will lead to inflation. Hence, checks need to be kept in place.


• The main goal of the fiscal policy in developing countries is the promotion of the highest possible rate of capital formation. Underdeveloped economies are in the constant deficit of the capital in the economy and thus, in order to have balanced growth accelerated rate of capital formation is required. For this purpose the fiscal policy has to be designed in a way to raise the level of aggregate savings and to reduce the actual and potential consumption of people.

• To divert existing resources from unproductive to productive and socially more desirable uses. Hence, fiscal policy must be blended with planning for development.

• To create an equitable distribution of income and wealth in the society.

• To protect the economy from the ills of inflation and unhealthy competition from foreign countries.

• To maintain relative price stability through fiscal measures.

• The approach to fiscal policy must be aggregate as well as segmental. the sectoral imbalances can be curbed by appropriate segmental fiscal measures.

• The government expenditure on developmental planning projects must be increased. For this deficit financing can be used. It refers to creation of additional money supply either by creation of new money by printing by government or by borrowing from the central bank.

• Public borrowing, loans from foreign nations etc can be used in the development of the resources for public sector.

• Fiscal policy in the developing economy has to operate within the framework of social, cultural and political conditions which inhibit formation and implementation of good economic policies.

• In order to reduce inequalities of wealth and distribution, taxation must be progressive and government spending must be welfare-oriented.

• The hindrances in the effective implementation of fiscal policy in the developing countries are loopholes in taxation laws, corrupt tax administration, a high population growth, extravagant governmental spending on non-developmental items, an orthodox society etc.

See also

External links


  • Heyne, P. T., Boettke, P. J., Prychitko, D. L. (2002): The Economic Way of Thinking (10th ed). Prentice Hall.

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