What is a contractive financial policy

Contractive fiscal policy: reducing government spending

Fiscal policy measures not only direct the state budget, but also have a direct impact on every private household - for example through tax increases.

A contractive fiscal policy is based on economic developments and aims to achieve macroeconomic stability through financial policy measures.

By lowering government spending and increasing taxes, a targeted influence is exerted on the economic cycle.

Fiscal policy in general

Fiscal policy unfolds its effectiveness in influencing taxes and government spending with the aim of macroeconomic stable growth with uniformly low inflation.

More on the subject:Fiscal Policy - Definition and Explanation

This goal was laid down in 1967 in the “Law for the Promotion of Stability and Growth of the Economy” (StabG) and contains 4 macroeconomic goals that are to be achieved.

The contractive fiscal policy also supports these 4 macroeconomic goals, which have become known as the “magic square”.

This is understood to mean the stability of the price level, a high level of employment and an external balance, which is rounded off by constant but reasonable economic growth.

Since these goals cannot be achieved without conflict, this square is also referred to as magical.

Objectives of contractive fiscal policy

The concept of countercyclical fiscal policy is used in the implementation of the contractionary economic policy.

This means that in times of economic boom, contractive fiscal policy measures should avoid overheating of the economy by always acting in the opposite direction to the course of the economy.

For example, overall economic demand and thus overall economic growth is reduced in order to ensure that the price level is stable.

More on the subject: Restrictive Fiscal Policy - Methods and Goals

Possibilities of implementation

There are several options for reducing government spending through contractive fiscal policies.

On the one hand, there would be a reduction in national debt and, on the other, the measure of a tax increase. In addition, subsidies are to be subject to a strict cut.

A reduction in government spending - for example by cutting public investment - leads to lower overall demand.

This in turn leads to a reduction in the total supply. A new price level arises. This process then continues to develop until the natural level of production is reached again.

In times of economic overheating, a reduction in government demand can at least temporarily counteract this risk.

In the long term, however, private demand will offset the reduced state demand.

Increasing income or corporate taxes is also popular as a contractionary fiscal policy measure.

However, the mode of action only unfolds when the additional tax revenue is shut down under the heading "Economic adjustment reserves".

The expansive fiscal policy as a counterpart

The counterpart to contractive financial policy measures is the expansive fiscal policy. This type of demand policy relies on precisely contradicting fiscal policy instruments such as contractive fiscal policy.

Here, for example, tax burdens are being reduced and public subsidies and social benefits are being expanded.

The expansive fiscal policy is used in weak economic phases and usually results in a budget deficit, which can then be compensated for by a contractive fiscal policy in boom phases.

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