Question

What is the main reason for employing contractionary fiscal policy in a time of strong economic growth?

Short answer

The fundamental justification for using contractionary fiscal policy during periods of rapid economic expansion (boom) is to combat inflationary pressures caused by increased aggregate demand.

Step-by-step solution

Step 1. Concept of federal policy and boom

The government's fiscal policy is known as fiscal policy. It is a weapon used by the government to impact the economy's output, employment, and pricing.

Expansion/Boom: An expansion period occurs when economic activity is at a rapid rate, i.e. when the economy enjoys quicker economic growth (associated with increases in output, employment, and inflation). Boom begins with the economy's trough (lowest point) and concludes with its apex (highest point) (highest point). Recovery precedes the boom, which is followed by the recession. It's an important aspect of the business cycle: Recession -- Recoveries -- Booms ---- Downturns

Step 2. Explanation

The use of government spending to boost aggregate demand, output, employment, and prices in the economy is known as an expansionary fiscal policy. It entails: a. Raising business taxes in order to lower after-tax profits.

b. Raising individual income taxes in order to reduce disposable income and, as a result, promote spending.

c. Directly reducing aggregate demand by reducing government purchases of final goods and services.

Consider the diagram below. Here,

AS = Aggregate Supply

A D= Aggregate Demand

P= Price level

Step 3. Explanation

The equilibrium output is $Y\left(0\right)$, and the equilibrium price is$P\left(0\right)$at first $\left(0\right)$. At first, the economy is in a state of equilibrium, with equilibrium GDP exceeding potential GDP, resulting in inflation (high prices). A contractionary fiscal policy changes the aggregate demand curve to the left$\left(A{D}_{(}0\right)\left(A{D}_{(}1\right)$. As a result, the new equilibrium output is $Y\left(1\right)$, while the new equilibrium price is $P_{(}1)$. In times when the level of equilibrium GDP is high due to very high aggregate demand, a contractionary fiscal policy lessens inflationary pressures/counters inflation.

Step 4. Explanation

As a result, the primary motivation for using contractionary fiscal policy during periods of rapid economic development (boom) is to combat inflationary pressures caused by high aggregate demand.