APMacro: Expansionary or Contractionary Policy Review

  • Fiscal policy allows policymakers to use changes in taxes and government spending to correct economic instability.
  • During a recession, aggregate demand falls, creating a recessionary gap which reduces output and employment. The government can use expansionary fiscal policy, reducing taxes, increasing government spending, or both to stimulate aggregate demand and restore the economy to full employment output. Expansionary fiscal policy creates a budget deficit, as the government spends more than its revenue in a year, and such deficits add to the national debt.
  • The government uses contractionary fiscal policy to combat inflation, raising taxes, reducing government spending, or both. Because of the ratchet effect, prices that rise tend not to fall to their previous levels, so the focus is on halting the rise of inflation and reducing aggregate demand to reduce further pressure on prices. The rise in tax revenue and fall in government spending would reduce the deficit or even cause a budget surplus, which would reduce the national debt.
  • The Fed has a number of monetary tools: the discount rate, reserve requirement, and open market operations, available to change the money supply and interest rates to affect real output, employment, and price levels.
  • The Fed uses expansionary monetary policy or easy money policy to expand the money supply during recessions. A decrease in the reserve requirement, a lower discount rate, or the Fed’s purchase of securities can achieve this result. As the money supply grows and interest rates fall. The increase in demand results in an increase in real GDP, employment, and price levels.
  • Contractionary or tight money policy is used to reduce the money supply during periods of significant inflation. An increase in the reserve requirement, an increase in the discount rate, or the Fed’s sale of securities will reduce the money supply, increasing interest rates. As a result, real output will fall back to full-employment output and employment will fall. Because of the ratchet effect, however, prices are unlikely to decline.

1. Fiscal & Monetary Policy #1-42
2. Phillips Curve #1-15



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