Question

Contractionary fiscal policy

1. Briefly discuss the consequences for the economy of the above policy action if the “crowding-out” effect is present in this economy. How will the multiplier process be affected?

Answer 1

1. Contractionary fiscal policy is a policy determined by the government. It consists of two tools: a. government taxes and government spending.

Taxes are raised and spending is reduced. This policy is generally used when economy is undergoing inflation and aggregate demand has shifted to right. This policy will reduce disposable income and as people spend less aggregate demand again shifts back and equilibrium is achieved as earlier.

Crowding out effect: It simply means that more government investment drives out private investment from the market. When govt. spends more then demand for money goes up and interest rates also rise. It leads to less investments from privates which might have been more efficient.

Multiplier process explains how investments by government creates additional purchasing power and helps to cover economic output gaps. It helps to create additional employment and increase GDP.

If crowding out effect is present and contractionary fiscal policy is followed then it may discourage investments and multiplier will reduce resulting in less GDP and unemployment.

It will however reduce inflationary pressures and real money value will increase.