Union Budget 2019: What is contractionary fiscal policy and how it influences level of activity in the economy

Contractionary fiscal policy involves increasing taxes or reducing spending when the economy is seeing high inflation or when prices shoot up due to supply constraints

FP Research June 20, 2019 14:35:07 IST
Union Budget 2019: What is contractionary fiscal policy and how it influences level of activity in the economy
  • Contractionary fiscal policy influences a nation's money supply and is used to direct a country's economic goals

  • Most contractionary fiscal policies unwind previous fiscal expansion, by reducing government expenditures

  • New finance minister Nirmala Sitharaman is due to present a budget on 5 July that many analysts expect to be expansionary

Fiscal policy involves altering the levels of government spending and tax rates aimed at influencing the level of activity in an economy. Fiscal policy can be expansionary or contractionary.

What is contractionary fiscal policy?

Contractionary fiscal policy involves increasing taxes or reducing spending when the economy is seeing high inflation or when prices shoot up due to supply constraints.

Contractionary fiscal policy influences a nation's money supply and is used to direct a country's economic goals. Most contractionary fiscal policies unwind previous fiscal expansion by reducing government expenditures.

The Reserve Bank of India (RBI) uses monetary policy tools such as cash reserve ratio (CRR), statutory liquidity ratio (SLR), repo, reverse repo, interest rates, etc., to control the money supply flows into the economy. These measures are used in times of higher-than-anticipated inflation. Discouraging spending by way of increased interest rates and reduced money supply helps government control rising inflation. However, it may also lead to increased unemployment.

Union Budget 2019 What is contractionary fiscal policy and how it influences level of activity in the economy

Representational image. Reuters.

Contractionary fiscal policy decreases the consumption of the products and profit of businesses, cutting down their investment expenditures. This decreases the Gross Domestic Product (GDP) and helps the government fight inflation.

The Narendra Modi government's new finance minister Nirmala Sitharaman is due to present the Union Budget on 5 July that many analysts expect to be expansionary, though she cannot afford to let the deficit slip too much.

Until then, the RBI will have to live with the uncertainty of the new minister's fiscal plans, while knowing that when the government does boost spending,  it will go some way to boosting banks' liquidity.

The central bank had lowered its January-March 2020 inflation forecast to 3.8 percent but warned it could be higher if food and fuel prices rise abruptly or if the fiscal deficit overshoots targets.

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