Fiscal Policy II

Contractionary fiscal policy involves reducing government spending or raising taxes to decrease aggregate demand.

The government may use this policy when an economy’s output is above its potential GDP.

Imagine an economy's actual output, Y₁, is above the level of potential GDP, Y_P. The aggregate demand curve AD₁ intersects the short-run aggregate supply curve SRAS₁ at the initial equilibrium, E₁.

When aggregate demand is very high, wages and prices go up, leading to inflation.

To reduce inflation, suppose the government raises taxes on individuals.

When people pay higher taxes, their disposable income falls. With lower disposable income, households cut back on spending, and this reduces consumer demand for goods and services.

As a result, aggregate demand decreases, shifting leftward.

The economy moves to a new equilibrium E₂, where output equals potential GDP.

The price level falls from P₁ to P₂.

This shows how contractionary fiscal policy can reduce inflation and bring the economy back to its potential output.