3 Tutorials that teach Contractionary Policy
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Contractionary Policy

Contractionary Policy

Author: Kate Eskra
This lesson covers the Contractionary Policy
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Source: Image of the Unemployment and Inflation Rates 2000-2013, creative commons, http://en.wikipedia.org/wiki/File:U.S._Phillips_Curve_2000_to_2013.png, Image of Phillips Curves created by Kate Eskra

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Hi. Welcome to macroeconomics. This is Kate. This tutorial is on contractionary policy. As always, my key terms are in red and examples are in green.

In this tutorial, we'll talk about what fiscal policy involves and how the government can use these policies to either expand or contract the economy. Specifically, we'll look at the contractionary tools available when the economy is experiencing inflation. You'll understand how these fiscal policy tools work and can actually have a multiplied effect in the economy. And finally, we'll interpret a Phillips curve and see its relationship between unemployment and inflation.

So there are two tools of fiscal policy, government spending and taxation. So fiscal policy is looking at the policies in these two areas. The idea is that the government can use these two tools to stabilize our economy's movement through business cycles.

So we know that the government spends a lot of money. And these are just a few examples. They spend money in things like national defense, education, and health care, welfare programs, and infrastructure, as well as a lot of other areas. So if the government wants to stimulate the economy, it can spend more money in order to create jobs and give people more money. This tutorial is going to focus on what they're going to do, though, when they want to contract the economy.

But first of all, let's look at what this government spending is all about. So we see the equation here for calculating GDP using the expenditure approach. Remember that y is our economic activity or GDP. And all spending in the economy is comprised of consumer purchases, which are c, investment in capital, usually by businesses, which is i, and then government purchases.

So in expansionary policy, the hope is that if the government kicks things off by starting and increasing some spending, that that would also encourage greater consumer spending then and business investment. So unfortunately, if they end up increasing taxes in order to pay for that increased government spending, it's going to be counterproductive.

Think about it. If they give more jobs and ultimately create some more money for you to spend, but then take more money from you by increasing taxes, it's very much counterproductive, right? So the idea is that without having to increase taxes, the government can do this. They can borrow money by selling treasury securities to finance the increased government spending needed to stimulate the economy. So they take on debt basically.

Keep in mind that when we repay the debt, tax revenue will then be needed. So taxation is the second tool of fiscal policy. And we know that federal, state, and local governments collect taxes from us in order to fund programs.

So another way that they could stimulate the economy, which would be expansionary policy, would be to cut taxes, to give people more money to spend. So by either increasing government spending or cutting taxes, the government's attempting to get people to spend money by injecting money into the economy.

So as a reminder, expansionary fiscal policy is when government spending is greater than tax revenue, because they're either increasing government spending, or cutting taxes, or both. But this tutorial is really focusing now on contractionary policy, which is either monetary or fiscal policy that's enacted to slow economic growth as measured by the GDP growth rate. Here we're focusing just on fiscal policy, not monetary policy.

So we would do the opposite of what I just talked about in the beginning. By either decreasing government spending or raising taxes, the government is then attempting to slow down the economy by getting people to spend less money. Basically instead of injecting money into the economy, they're now taking money out. So contractionary fiscal policy is when our tax revenue is greater than our government expenditures. OK.

So this can have a multiplied effect, just as it did with expansionary policy. If the government decreases spending or raises taxes, that could have a multiplied effect by discouraging consumer spending and business investment. So as just one example, if I get laid off as a government employee, as a result of decreased spending, I now have less money to go out and spend in restaurants, on vacations, et cetera.

Those places of business now have less money, because I'm not spending money with them. So they have less money to pay their workers. And then those workers will in turn have less money to spend elsewhere. So you can see that this has a multiplied effect.

The big idea basically that you need to understand is that for every $1 the government withdraws from the economy, this will result in GDP decreasing by more than $1 by that multiplied effect. So here's how we find the potential multiplied effect. We have to find the consumption multiplier, which is 1 divided by 1 minus the MPC. And the MPC is just consumers' Marginal Propensity to Consume. Really it's the percentage of any additional income that people are going to spend versus save.

So if the government wants to decrease GDP, and they're trying to do that by cutting $10 billion in government spending-- let's say our MPC is 0.75-- what overall effect will this have on the economy? Will it really only withdraw $10 billion, or more?

Well, we know our MPC is 0.75. That makes our consumption multiplier, , then, 1 divided by 0.25, because 1 minus our MPC is 0.25. That makes our multiplier 4. So this will have a multiplied effect by four times. If the government spending decreases by $10 billion, then it could ultimately result in $40 billion less in overall economic activity. OK.

So why does the government engage in a contractionary policy? Really they only do it when there's a major inflationary risk. It's the only way to cool down the economy and slow down the rate of inflation to reduce economic activity. Naturally what this is going to do is cause an increase in unemployment, which is never really the goal necessarily, but it's the only way to go about taking away this inflationary risk.

It's actually weird to think about it this way. But when our unemployment rate gets too low, too far below our natural rate of unemployment-- around 5%-- when it gets way below that, that poses a major inflationary risk. So politicians have to consider this trade-off. When they decide that the inflationary risk is just really high, they then are willing to accept higher levels of unemployment.

And the Phillips curve is going to show this relationship between inflation and unemployment. OK. So this curve suggests there's an inverse relationship between annual inflation rates and unemployment rates in an economy.

So the idea is that when we have very low unemployment-- as we do here at 2%, way below our full employment rate of about 5%-- that corresponds with a very high inflation rate of 10%. But when we have very low inflation, that's going to start increasing the unemployment rate.

So in this example that I just sketched this curve out here-- in this example, if inflation is very high-- at 10%-- what the government could do, because that's a pretty significant inflationary risk, the government could spend less money or raise taxes-- as we talked about with contractionary policy. If we went from just one point to the next point, that would definitely result in lower inflation. A much more acceptable inflation rate-- which usually the goal is about 2% annually-- so we could hit that target. But the trade-off was a higher unemployment rate, a little bit over our natural rate of unemployment of 5%. OK.

And the reason that that happened is because overall demand in the economy fell as they took money out of the economy. So this shows what happens when the Fed engages in these contractionary policies. When the economy's experiencing extremely low unemployment, though-- like this 2% example-- inflation is so high.

So really the Fed can reduce inflation and bring unemployment to its natural rate of around 5%. So the way I put these numbers are extremes, but it's very possible that they could bring this inflation rate down somewhere in here at a 5% unemployment rate.

So critics of this model sometimes point to the 1970s, when our economy experienced really high rates of inflation at the same time as high unemployment. That's known as stagflation. So we wouldn't be able to explain this with this simplified model, with just this one curve, because there were times in the 1970s when inflation was well over 10% coupled with an unemployment rate over 8%.

So that would put us somewhere out here. We can't just move along this simplified Phillips curve and find that combination of unemployment and inflation. So we would actually need to suggest that this Phillips Curve could move over time. And that would be a much higher Phillips curve on this example graph that I've drawn.

And I just found this and wanted to show you. I thought it was interesting. This just plots all of the different combinations of unemployment and inflation rates that our economy experienced between 2000 and 2013. So you can see the general relationship that does exist between these two, as the Phillips curve suggested, but just at different levels. So these would be noticing that the Phillips curve could be at different points.

So here are all of the things that we went over in this tutorial on contractionary policy. Thanks so much for listening. Have a great day.

Notes on "Contractionary Policy"

Terms to Know

Contractionary Policy

Either monetary or fiscal policy that is enacted to slow economic growth (as measured by the GDP growth rate).