Contractionary policies are macroeconomic tools designed to combat economic distortions caused by an overheating economy. Contractionary policies aim to reduce the rates of monetary expansion by putting some limits on the flow of money in the economy.

To enact contractionary fiscal policy, the government may decrease spending, increase taxes, and enact a combination of decreased spending and increased taxation.

Spending and the deficit One impact of cutting government spending is that it will help reduce annual government borrowing and help reduce the total public sector debt. This is because if spending cuts cause lower growth, it will lead to lower tax revenues and higher spending on benefits.

Expansionary fiscal policy is used to kick-start the economy during a recession. It boosts aggregate demand, which in turn increases output and employment in the economy. In pursuing expansionary policy, the government increases spending, reduces taxes, or does a combination of the two.

Do changes in government spending and taxation have equal results?  NO … if changes are equal, government spending will have a larger impact since it has a direct effect.  Taxes change income and, thus, consumption by an amount equal to the tax times the marginal propensity to consume.

Increased government spending is likely to cause a rise in aggregate demand (AD). This can lead to higher growth in the short-term. It can also potentially lead to inflation.

A Fiscal stimulus could involve:

• Tax cuts. Cutting income taxes increases disposable income and therefore causes people to spend more.
• Government spending increases. Higher government spending represents an injection into the economy and should cause higher Aggregate demand.

In the United States, fiscal policy is directed by both the executive and legislative branches of the government. In the executive branch, the President and the Secretary of the Treasury, often with economic advisers’ counsel, direct fiscal policies.

What is another word for fiscal policy?

Limits of fiscal policy include difficulty of changing spending levels, predicting the future, delayed results, political pressures, and coordinating fiscal policy. Compare and contrast demand-side (Keynesian) economics and supply-side economics.

As the economy exits a recession and begins to grow at a healthy pace, policymakers may choose to reduce fiscal stimulus to avoid some of the negative consequences of expansionary fiscal policy—such as rising interest rates, growing trade deficits, and accelerating inflation—or to manage the level of public debt.

A government experiences a fiscal deficit when it spends more money than it takes in from taxes and other revenues excluding debt over some time period. An increase in the fiscal deficit, in theory, can boost a sluggish economy by giving more money to people who can then buy and invest more.

A high fiscal deficit can also be good for the economy if the money spent goes into the creation of productive assets like highways, roads, ports and airports that boost economic growth and result in job creation.

The fiscal deficit can arise either due to revenue expenses overshooting income or increase in capital expenditure. The fiscal deficit matters because it indicates the extent by which government spending exceeds its income and the total borrowings needed by it to fill this gap.

Top 20 countries with the largest deficit

GDP Based on Share of 2019 World Total, in %

• China. 2019 Nominal GDP in Current U.S. Dollars: $14.34 trillion3
• Japan. 2019 Nominal GDP in Current U.S. Dollars: $5.08 trillion3
• Germany. 2019 Nominal GDP in Current U.S. Dollars: $3.86 trillion3
• India.
• United Kingdom.
• France.
• Italy.
• Brazil.

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