Question

Explain contractionary fiscal policy and it's tools.

Provide a graph (properly labeled) that shows an inflationary gap AND the shifts that contractionary fiscal policy will create to solve the gap in your above explanation.

Answer 1

The contractionary fiscal policy is used by the Federal government to stabilize the economy and correct the situation of inflationary gap in the economy. this is done by reducing the aggregate demand to the level which is required to maintain the full employment. Contractionary fiscal policy has mainly two tools:

1. Increase in taxes– increase in taxes decreases the disposable income in the economy. This leads to reduced consumer spending which decreases aggregate demand and eliminates the inflationary gap.
2. Decrease in government spending– the Federal government reduces its spending which directly reduces the aggregate demand and eliminates the inflationary gap.

The required diagram is given below: