What is contractionary fiscal policy?
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.
There are two main tools of fiscal policy. These tools are taxation and government spending. The government can use either or both of these tools to try to get the economy to slow down. Basically, the government gets the economy to slow down by taking money away from consumers. This means that they have less to spend and AD goes down.
The government can do this either through taxes, through spending, or both. In order to take money out of consumers’ pockets, the government can raise taxes. Obviously, people will then have less to spend and AD will drop. The government can also reduce government spending. This will not directly take money from the people. However, it will reduce the amount that the government would have paid out in the future. This means that people will have less money to spend and AD will drop.
Contractionary fiscal policy, then, involves tax increases, spending decreases, or both. It is meant to slow an economy down.