What Is an Example of Contractionary Fiscal Policy

Governments pursue restrictive fiscal policies by raising taxes or cutting public spending. In its crudest form, this policy sucks money from the private sector in the hope of slowing down unsustainable output or driving down asset prices. Nowadays, increasing the level of taxation is rarely seen as a viable contraction measure. Instead, most restrictive fiscal measures end the previous fiscal expansion by cutting public spending – and even then only in target sectors. The opposite of contractionary monetary policy is expansionary monetary policy. How do governments and central banks measure when an economy overheats? In general, looking at the rate of inflation. It is natural that an increase in demand triggers an increase in the prices of goods and services. The United States, for example, sees an average annual inflation rate of 2% as normal. These measures effectively reduce the money supply. Individuals and businesses have less money on hand, and what they buy – directly or by borrowing – costs them more. In the United States, the Federal Reserve`s monetary policy of contraction consists of three main instruments: In the United States, a policy of contraction is generally conducted by raising the target federal funds rate, that is, the interest rate that banks charge each other overnight, to meet their reserve requirements. To cool this overheated economic engine, a country`s central bank will implement a contractionary monetary policy to slow rapid growth and price increases. The policy of contraction occurred especially in the early 1980s, when then-Federal Reserve Chairman Paul Volcker finally halted the rise in inflation of the 1970s.

At their peak in 1981, target federal funds interest rates were approaching 20%. Measured inflation rose from almost 14% in 1980 to 3.2% in 1983. For example, suppose a person wants to buy a house and the interest rate on a mortgage provided by a bank was 3%. But the following week, the federal funds rate was raised, leading the bank to raise the mortgage rate to 5%. As might be expected, it is implemented in the opposite phase of an economic cycle: a phase of contraction in which the economy slows down and GDP declines. The goal is to slow the pace of the economy by reducing the money supply or the amount of easily depositing liquidity and funds circulating throughout the country. This is the opposite of expansionary monetary policy. But when inflation exceeds its target growth rate of 2%, it acts as a warning – and becomes the main catalyst for the implementation of a contractionary monetary policy. Restrictive monetary policy is a macroeconomic tool that a central bank – in the United States, the Federal Reserve – uses to reduce inflation.

The purpose of contractionary monetary policy is to prevent these brutal shocks. To slow economic growth, the central bank must curb demand by making it more expensive to buy goods and services, at least for a while. Although the initial effect of contraction policies is to reduce nominal gross domestic product (GDP), which is defined as gross domestic product (GDP) valued at current market prices, this often ultimately leads to sustainable economic growth and smoother business cycles. A concrete example of a policy of contraction at work can only be found in 2018. As reported by the Dhaka Tribune, the Bangladesh Bank has announced its intention to issue a contractionary monetary policy to control the supply of credit and inflation and, ultimately, maintain economic stability in the country. When the economic situation changed in the following years, the Bank switched to an expansionary monetary policy. Restrictive monetary policy is driven by the rise in the various key interest rates controlled by modern central banks or other growth-stimulating agents. in the money supply.

The goal is to reduce inflation by limiting the amount of active money circulating in the economy. It also aims to suppress unsustainable speculation and capital investment that may have triggered previous expansionary measures. If contraction policies reduce the degree of displacement in private markets, this can have a stimulating effect by allowing the private or non-governmental part of the economy to grow. This was true during the forgotten depression of 1920-1921 and in the period immediately after the end of World War II, when leaps in economic growth followed massive cuts in public spending and rising interest rates. Contraction policies are often linked to monetary policy, with central banks such as the Federal Reserve being able to implement this policy by raising interest rates. Contraction policy is a monetary measure that refers either to a reduction in public spending – especially deficit spending – or to a reduction in the rate of monetary expansion by a central bank. It is a kind of macroeconomic tool to combat rising inflation or other economic distortions caused by central banks or government intervention. The policy of contraction is the exact opposite of expansive politics. If a country`s GDP grows too fast, causing inflation to exceed a desirable rate of 2%, central banks will implement a monetary policy of contraction. Of course, the trick of a contractionary monetary policy is to gently contain the galloping economy, but never to stop it completely in its tracks.

Runaway inflation is not a common problem. This, combined with the fact that governments want a growing economy, means that contractionary monetary policy has not been applied as often. .