What is Contractionary Fiscal Policy?

Fiscal policy can also contribute to pushing aggregate demand beyond potential GDP in a way that leads to inflation.

The graph below shows, a very large budget deficit pushes up aggregate demand, so that the intersection of aggregate demand (AD₀) and aggregate supply (SRAS₀) occurs at equilibrium E₀, which is an output level above potential GDP. Economists sometimes call this an “overheating economy” where demand is so high that there is upward pressure on wages and prices, causing inflation. In this situation, contractionary fiscal policy involving federal spending cuts or tax increases can help to reduce the upward pressure on the price level by shifting aggregate demand to the left, to AD₁, and causing the new equilibrium E₁ to be at potential GDP, where aggregate demand intersects the LRAS curve.

The economy starts at the equilibrium quantity of output Y₀, which is above potential GDP. The extremely high level of aggregate demand will generate inflationary increases in the price level. A contractionary fiscal policy can shift aggregate demand down from AD₀ to AD₁, leading to a new equilibrium output E₁, which occurs at potential GDP, where AD1 intersects the LRAS curve.

Again, the AD–AS model does not dictate how the government should carry out this contractionary fiscal policy. Some may prefer spending cuts; others may prefer tax increases; still others may say that it depends on the specific situation. The model only argues that, in this situation, the government needs to reduce aggregate demand.

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