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Home > Economics FAQs Blogs > Why might a government use contractionary fiscal policy during a boom to reduce employment?

Why might a government use contractionary fiscal policy during a boom to reduce employment?

Relevant Topics

This question pertains to topics in Macroeconomics, such as Fiscal Policy and Unemployment

Definitions:

Contractionary Fiscal Policy: This is a type of fiscal policy where a government reduces its spending or increases taxes with the aim of slowing down an overheating economy.

Boom
: A boom is a period of rapid economic expansion resulting in higher GDP, lower unemployment, and rising asset prices.

Detailed Explanation:

During a boom, the economy is operating at or near its full capacity, which can lead to increased inflationary pressures. To control this, a government might decide to use a contractionary fiscal policy. By either increasing taxes or reducing government spending, the aim is to decrease aggregate demand in the economy.

Reducing aggregate demand can help to ease inflationary pressures. It may also serve to "cool" the economy, bringing it back from potential over-heating. As a side effect, however, it could lead to a reduction in employment, as lower demand can mean businesses need fewer employees.

While the reduction in employment might seem like a negative outcome, during a boom, the economy might be experiencing a very low unemployment rate - possibly even lower than the natural rate of unemployment (the lowest rate of unemployment that an economy can sustain over the long run). This is known as over-employment, and it can lead to wage inflation as firms compete for scarce labour resources. By implementing contractionary fiscal policy, the government could aim to bring employment levels back towards the natural rate of unemployment.

Recent: 

The UK Government applied contractionary fiscal policy measures after the 2008 financial crisis to try and reduce a large budget deficit. While the primary goal was to reduce the deficit and restore public finance stability, one side effect was a higher unemployment rate.

In the early 1980s, the U.S. Federal Reserve used contractionary monetary policy to combat high inflation, which is similar in impact to contractionary fiscal policy. While this helped to lower inflation, it also led to a recession and an increase in unemployment.

Summary:

In conclusion, a government might use contractionary fiscal policy during a boom to reduce employment in order to control inflationary pressures and to bring the unemployment rate back towards the natural rate. Although it can lead to higher unemployment in the short term, it aims to ensure more sustainable economic growth over the long term. It's essential to note, however, that these policies must be implemented with care, as too strong a contractionary impulse could risk tipping the economy into recession.

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