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- Well, expansionary fiscal policy tries to reduce a recessionary gap while a contractionary fiscal policy tries to reduce an inflationary gap.
- Well, there are two different types of fiscal policy: expansionary and contractionary.
- What do they each do?
- Yes! The contractionary fiscal policy is what we need to do now in an inflationary gap. We need to reduce the amount of money in the people's hands, to reduce their spending power. These policies typically decrease government spending, government transfers, and increase taxes. It will shift our economy back to equilibrium and potential output.
- In the recessionary gap, the economy is producing at a real output level that is less than the potential output. Therefore there is high unemployment since the economy is producing less than they should. An expansionary fiscal policy tries to give more money back to the people, whether it is through increased government transfers (like social security) or reducing taxes.
- Oh, I see, so a contractionary fiscal policy should be the opposite of that!
- You're right! Sometimes it is not practical to make any fiscal policy since by the time everything is decided and put into place, the economy might have already recovered! But let's not worry about that now! Let's eat our burgers!
- Oh I see! That makes sense! I guess it is pretty hard to make these decisions so short notice!
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