Purpose
The purpose of contractionary fiscal policy is to slow growth to a healthy economic level. That’s between 2% to 3% a year. An economy that grows more than 3% creates four negative consequences. When governments cut spending or increase taxes, it takes money out of consumers’ hands. That also happens when the government cuts subsidies, transfer payments including welfare programs, contracts for public works, or the number of government employees. Shrinking the money supply decreases demand. It gives consumers less purchasing power. That reduces business profit, forcing companies to cut employment.
Why Politicians Rarely Use It
Elected officials use contractionary fiscal policy much less often than expansionary policy. That’s because voters don’t like tax increases. They also protest any benefit decreases caused by reduced government spending. As a result, politicians who use contractionary policy are soon voted out of office. The unpopularity of contractionary policy results in ever-increasing federal budget deficits. To make up for the deficit, the government just issues new Treasury bills, notes, and bonds. These annual budget deficits worsen the U.S. debt. It’s over $27 trillion, more than what the United States produces in a year. Over the long run, the debt-to-GDP ratio is unsustainable. In time, purchasers of U.S. Treasurys will worry that they won’t get repaid. They will demand higher interest rates to compensate them for the added risk. Higher rates will slow economic growth. The economy suffers the effects of contractionary monetary policy whether it wants to or not. That’s because they must follow balanced budget laws. They aren’t allowed to spend more than they receive in taxes. That’s a good policy, but the downside is it limits lawmakers’ ability to recover during a recession. Unless they have a surplus when the recession hits, they must cut spending right when they need it most.
Examples
President Bill Clinton used contractionary policy by cutting spending in several key areas. First, he required welfare recipients to work within two years of getting benefits. After five years, benefits were cut off. He also raised the top income tax rate from 31% to 39.6%. President Franklin D. Roosevelt used contractionary policy too soon after the Depression. He was reacting to political pressure to cut the debt. The Depression came roaring back in 1932. It didn’t end until FDR geared up spending for World War II. That was a massive return to expansionary fiscal policy.
Contractionary Fiscal vs. Monetary Policy
Contractionary monetary policy occurs when a nation’s central bank raises interest rates and decreases the money supply. It’s done to prevent inflation. The long-term impact of inflation can be more damaging to the standard of living than a recession. Expansionary monetary policy boosts economic growth by lowering interest rates. It’s effective in adding more liquidity in a recession. The benefit of monetary policy is that it works faster than fiscal policy. The Federal Reserve votes to raise or lower rates at its regular Federal Open Market Committee meeting. It takes about six months for the added liquidity to work its way through the economy.
