Contractionary Fiscal Policy

Question 1

Define contractionary fiscal policy

Answer 1

• reduce G (direct component of AD)
• increase taxes (T) (corporate income tax, personal income tax)
• leftward shift of AD, AD fall
• most effective if rise in AD is due to rise in G, C and/or I

Question 2

Example of contractionary fiscal policy

Answer 2

• Turkey 2019
• International monetary fund recommended to use CFP
• reduce 20% inflation rate

Question 3

Reduce G

Answer 3

• G is a component of AD, directly affects AD
• e.g. 2008 SG gov delay expenditure on non-essential projects e.g. public housing construction
• leftward shift of AD curve (AD, SRAS curve graph)
• equilibrium shifts from E0 to E1
• inflation is reduced as P drops

Question 4

Evaluation of reducing G (small G as percentage of GDP)

Answer 4

• SG: G as a percentage of GDP is already small (16%), difficult to reduce that already low level to reduce inflation

Question 5

Evaluation of reducing G (development of country)

Answer 5

• difficult to make sudden cuts in G
• in areas like health, defence, education
• some projects once started, cannot be stopped
• need to continue spending on ongoing long-term project
• reduction in G would affect economic growth and development

Question 6

Evaluation of reducing G (politically unpopular)

Answer 6

• e.g. once a decision made to increase pay of gov workers, commit gov to higher spending, difficult to reverse it

Question 7

Increase in T

Answer 7

• can increase direct taxes ie. personal income tax, corporate income tax
• higher personal income tax, lesser DI, C falls
• higher corporate income tax, lesser post-tax profit, I falls
• AD falls ceteris paribus, downward pressure on GPL

Question 8

Evaluation of increasing T (social)

Answer 8

• increase direct taxes, discourage work effort, savings and investments
• increase hardship on ppl as their DIs are already dwindling due to fall in value of money

Question 9

Evaluation of increasing T (uncertain effects)

Answer 9

• uncertain of reaction of general public/how they respond
• difficult to determine exact increase in T to reduce inflation rate
• if T is too high, may result in slower economic growth (more harm than good)

Question 10

Other limitation of CFP

Answer 10

1. Time lags

2. Conflict of macroeconomic goals (output)

Question 11

Time lags (-ve)

Answer 11

• recognition lag, decision-making lag, implementation lag, response lag
• dependent on efficiency of gov
• process usually hindered by bureaucracy
• time lag too long, overall deflationary effect of decreased spending not strong enuf
• economy may have worsened, stronger dose of intervention needed

Question 12

Conflict with macroeconomic goals (-ve)

Answer 12

• CFP reduces AD
• contractionary effect on national output
• country’s economic growth suffers in the short run