Contractionary Policy

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Definition: Contractionary Policy

Y = E + I + G + (X-M)

The above equation specifies the GDP of an economy. In contractionary policy, the size of GDP decreases. In contractionary fiscal policy, the government expenditure decreases or the taxes increase. The decrease in government expenditure decreases spending in public sector which push down demand, thus pushing the economy to a lower level. Increase in taxes is also contractionary as leads to a lower disposable income and thus reducing the consumer spending power resulting in lower total GDP.

In contractionary monetary policy, the central bank increases the policy rates such as the repo rates in India, this results in reduced money supply in market. The central bank sells government bonds and securities to the banks which reduces the money supply with banks thus reducing interbank lending pushing the interest rates up which makes it difficult for households and businesses to borrow thus reducing the money supply in market and pushing down consumption. This stand is generally taken up by the central bank when the economic environment is inflationary so as to reduce the prices.

For a growth of economy, the both monetary and fiscal policies have to be expansionary which will control inflationary affect at the same time pushing up consumption.

Hence, this concludes the definition of Contractionary Policy along with its overview.

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