Definition: Contractionary fiscal policy is an economic method that governments and central banks use to reduce the money supply in the economy to combat inflation. In other words, it represents the tools that the government can use to help stabilize the economy and smooth out bubbles and upswings where inflation is more likely.
What Does Contractionary Fiscal Policy Mean?
Contractionary Fiscal Policy is mostly used by the Federal Reserve in order to calm down an extremely “hot”, or fast-growing, economy. This can be dangerous due to the runaway inflation, which is a situation in a fast-growing economy where inflation increases drastically and erodes the purchasing power of consumers.
The Federal Reserve mainly enacts contractionary policy through one of three ways:
1. raising the rate the FED lends to banks, which in turn makes bank loans more expensive for companies and decreases the money supply
2. increasing the reserve requirements of banks, which means that these institutions can lend out less money which decreases economic activity
3. selling or calling government bonds, which reduces the money supply in the form of bond purchases.
Let’s look at an example.
Let’s assume the United States economy is growing at a furious rate of 10% GDP per year. The Federal Reserve, knowing this level of economic growth is unsustainable and can lead to hyperinflation, enacts contractionary fiscal policy. Let’s say the money supply is $1,000,000, and the Fed wants to decreases it by $500,000. The FED raises the interest rates to 3% from 1.5%, making it twice as expensive for banks to borrow from the Fed. This, in turn, makes it even more expensive for companies to borrow money. The more expensive it, the less companies will actually borrow money.
Secondly, the Fed increases the reserve requirements of banks from 20% to 50%, which drastically reduces the amount the banks can loan out. Now, bank loans are more expensive and extremely scarce, which slows economic activity and investment, ultimately shrinking the money supply to $700,000.
Lastly, the Fed can directly affect the money supply by selling government bonds at slightly higher rates, or call back existing bonds. They sell $200,000 worth of government bonds to consumers, and thus have reduced the money supply to $500,000.
Contractionary Fiscal Policy holds important tools for central banks around the world to keep their economies in check and on sustainable, stable growth. It is vital to avoid hyperinflation, but it can also create deflation and stifle an economy if it is not used properly. The lagging indicators must be watched carefully and it should be used sparingly.