Contractionary Fiscal Policy
🔹 Two levers: Spend less or tax more
Imagine the economy is like a bicycle speeding downhill. Sometimes you need to gently apply the brakes. The government has two brake pedals:
⬇️ Government spending (G) – The state buys fewer new roads, school buses, or military equipment. This directly lowers the flow of money.
⬆️ Taxes (T) – Families and businesses pay more to the treasury. They have less money left to spend on pizzas, cars, or machinery.
When the government cuts spending or raises taxes, total spending in the country — economists call it aggregate demand — shrinks. Prices stop rising so fast, and the economy cools down.
Formula: $\Delta Y = \text{multiplier} \times \Delta G$.
🔹 What happens inside a family budget? (Tax increase story)
The Garcia family earns $5,000 per month. They usually spend $4,500 and save $500. One year the government increases income tax. Now the family pays $200 more each month. Their disposable income drops to $4,800. They decide to cut back: they eat out less often and postpone buying new sneakers. The restaurant owner and the shoe store now earn less. They in turn reduce working hours. This ripple effect is the contractionary policy at work.
🔹 Government stops a bridge project (Spending cut story)
A city planned to build a new bridge for $50 million. Steel, cement, and engineers were ready. But to fight inflation, the federal government cancels the project. The construction company loses the contract, lays off 40 workers. Those workers now buy less gasoline and groceries. Local gas stations and supermarkets see lower sales. This is how a cut in public spending reduces demand step by step.
📊 Comparing the two tools
| Tool | How it works | Example | Effect on demand |
|---|---|---|---|
| ↓ Government spending | Fewer public works, defense, services | Cancel high-speed rail | Direct and immediate drop |
| ↑ Taxes | People & businesses keep less income | Raise sales tax from 6% to 8% | Gradual, spread over millions |
🔬 Real‑world case: Canada in the 1990s
In the early 1990s, Canada had a large budget deficit[1] and high inflation. The government cut spending on defence and transportation and also increased taxes. By 1997, the budget was balanced and inflation fell from about 5.5% to 1.6%. This is a classic example of contractionary fiscal policy cooling an overheated economy.
❓ Important Questions
A1: It works well when the economy is growing too fast. But if the government cuts spending during a recession, it can make unemployment worse. Timing is crucial.
A2: Yes, it is often unpopular. Governments prefer spending cuts. But sometimes both are needed to stop prices from rising too quickly (inflation) and to prevent dangerous bubbles.
A3: Fiscal policy uses government budget (taxes & spending). Monetary policy uses interest rates and money supply, controlled by the central bank. Both try to reduce demand, but through different channels.
📘 Footnote
[1] Budget deficit: when a government spends more money than it collects in taxes during one year.
Aggregate demand (AD): total spending in a country: consumption, investment, government purchases, and net exports.
Multiplier: the ratio of a change in GDP to the initial change in spending or taxes.
GDP (Gross Domestic Product): the total value of all final goods and services produced in a country.