Contractionary Fiscal Policy | A-Level Economics Model Paragraph (AQA, Edexcel, OCR)

Contractionary fiscal policy can be used to reduce inflation. Inflation is when there is a rise in average price level. Contractionary fiscal policy involves reducing government spending or increasing tax rates. AD = C + I + G + (X - M), so if G (government spending) decreases, AD would decrease, as shown below with the left shift in the AD curve.

AD LEFT SHIFT DIAGRAM

The diagram shows that the price level would fall from PL1 to PL2. This will benefit those on stagnant wages as they will not have to worry about their purchasing power and their disposable incomes falling due to higher cost of living, which also means they will be able to experience better living standards.

However, the diagram also shows a fall in real GDP from y1 to y2 which shows an economic downturn, and also greater levels of unemployment. Labour is a derived demand, so if businesses experience lower demand for their goods and services, they may cut jobs. This could mean that there is an increase in inequality and those without a job would suffer from low or no disposable income and see even further decline in their living standards.

Due to a combination of job cuts, uncertainty, and low consumer confidence, AD could shift even further to the left, and this could also lead to business confidence falling, which would cause even further left shifts in the AD curve. This is a negative multiplier effect. If this spirals for two consecutive quarters, it would be called a recession, and it is an outcome the government should be careful to avoid.

However, one benefit of contractionary fiscal policy is that it allows the government to run a budget surplus (where tax revenue exceeds government spending). This can reduce national debt, which allows the government to reduce interest repayments, which can benefit the economy in the future, as the government can use funding on services such as the NHS/ education.

Overall, contractionary fiscal policy may be required to reduce national debt, and to reduce inflation but it should be used carefully as it can lead to worse living standards and a recession if it is not controlled.