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A contractionary fiscal policy is a fiscal policy that is meant to slow an economy down. It is meant to decrease aggregate demand (AD) to slow an overheating economy. When we talk about an economy that is “overheating” we mean that it is suffering from inflation. More specifically, we mean that it is suffering from demand-pull inflation. Demand-pull inflation is a kind of inflation that happens because AD is too high. There are too many dollars out there in the economy chasing a set quantity of goods and services. This allows general price levels to rise.
An economy would pursue a contractionary fiscal policy, then, if it is suffering from demand-pull inflation. Countries do not want to suffer from inflation because it leads to economic instability. People do not know what their money will be worth in the future, which makes them much less likely to do things like investing. Therefore, the people who make policy for an economy may use contractionary fiscal policy at times to prevent this from happening.
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