Question

Using words and graphs analyze the macroeconomic effects of contractionary fiscal policy in the short run. Provide as much detail as possible.

Answer 1

In IS-LM model, contractionary fiscal policy shifts IS curve to left, decreasing interest rate and decreasing output. In following graph, IS0 and LM0 are initial IS and LM curves intersecting at point A with initial interest rate r0 and output Y0. As contractionary fiscal policy is implemented, IS0 shifts left to IS1, intersecting LM0 at point B with lower interest rate r1 and lower output Y1.

In AD-AS model, contractionary fiscal policy reduces government spending or increases taxes, both of which decrease aggregate demand and shifts AD curve to left, reducing both price level and real GDP. In following graph, AD0 and SRAS0 are initial aggregate demand and short run aggregate supply curves intersecting at point A with initial price level P0 and real GDP Y0. As contractionary fiscal policy takes place, AD0 shifts left to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1.