No Such Thing as a Free Lunch: Principles of Economics (Part 131)

With interest rates artificially low, consumers reduce savings in favor of consumption, and entrepreneurs increase their rates of investment spending.

Steve Hanke

Money, the Interest Rate, and Output: Analysis and Policy

(Part C)

by

Charles Lamson

Contractionary Policy Effects

Any government policy that is aimed at reducing aggregate output (income) (Y) is said to be contractionary. Where expansionary policy is used to boost the economy, contractionary policy is used to slow the economy.

Why would the government adopt policies designed to reduce aggregate spending? As we will see in the next several posts, one way to fight inflation is to reduce aggregate spending. When the inflation rate is high, or the government believes it may rise soon, the government may use its powers to contract the economy. Before we discuss the contractionary policies that the government has undertaken in recent years, we need to discuss how contractionary fiscal and monetary policy work.

Contractionary Fiscal Policy: Decrease in Government Spending (G) or an Increase in Net Taxes (T) A contractionary fiscal policy is a decrease in government spending (G) or an increase in net taxes (T) aimed at decreasing aggregate output (income) (Y). The effects of this policy are the opposite of the effects of an expansionary fiscal policy (See last post).

Effects of a contractionary fiscal policy:

Contractionary Monetary Policy: A Decrease in the Money Supply A contractionary monetary policy is a decrease in the money supply aimed at decreasing aggregate output (income) (Y). The level of planned investment spending is a negative function of the interest rate: the higher the interest rate, the less planned investment there will be. The less planned investment there is, the lower planned aggregate expenditure will be, and the lower the equilibrium level of output (income) (Y) will be. The lower equilibrium income results in a decrease in the demand for money, which means that the increase in the interest rate will be less than it would be if we did not take the goods market into account.

Effects of a contractionary monetary policy:

The Macroeconomic Policy Mix

Policy mix refers to the combination of monetary and fiscal policies in use at a given time. A policy mix that consists of a decrease in government spending and an increase in the monetary supply would favor investment spending over government spending. This is because both the increased money supply and the fall in government purchases would cause the interest rate to fall, which would lead to an increase in planned investment. The opposite is true for a mix that consists of an expansionary fiscal policy and a contractionary monetary policy. This mix favors government spending over investment spending. Such a policy will have the effect of increasing government spending and reducing the money supply. Tight money and expanded government spending would drive the interest rate up and planned investment down.

There is no rule about what constitutes the "best" policy mix or the "best" composition of output. On this, as on many other issues, economists (and others) disagree. In part, someone's preference for a certain composition of output---say, one weighted heavily toward private spending with relatively little government spending depends on how that person stands on such issues as the proper role of government in the economy.

Table 1 summarizes the effects of various combinations of policies on several important macroeconomic variables. If you can explain the reasoning underlying each of the effects shown in the table you can be satisfied that you have a good understanding of the links between the goods market and the money market. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 524-526*

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