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Expansionary and Contractionary Fiscal Policies

Expansionary and contractionary fiscal policies are the two tools implemented by the government to control economic growth. They both use government spending and tax policies to regulate the flow of money. The expansionary policy reduces taxes and increases government spending to increase the flow of money to the economy, while contractionary policy decreases spending and increases taxes to reduce the supply of money. Expansionary policy is generally used during a recession to stimulate the economy, while the contractionary policy is implemented when the economy is expanding too fast to slow down inflation.

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The crowding-out effect is a theory claiming that the rise in the private sector spending lowers down the spending in the private sector. It is generally a result of the government’s expansionary fiscal policy when the government increases its spending to boost economic activity. It leads to an increase in interest rates, which affects private investment decisions. The crowding-out effect causes problems for the government, investors, and consumers. On the national level, it can lead to lesser income in the economy. On the investment level, it discourages businesses from making major investments, slowing down economic activity. On the consumer level, it causes a decrease in spending, which also affects the economy.

The required reserve ratio is the regulation that sets the minimum amount of funds that must be held by a commercial bank each night. The discount rate is the rate that the Federal Reserve Banks charge commercial banks on short-term (overnight) loans. The federal funds rate is the rate at which depository institutions—commercial banks and credit unions—reserve funds to each other overnight. The prime rate is the rate at which commercial banks lend money to their most creditworthy customers.

Tight money policy and easy money policy are two types of tools used by a central bank to influence economic growth. Tight money policy is aimed to reduce the demand for money, restrict credit, and raise interest rates. It is mainly used to reduce the effects of inflation caused by a high amount of money in circulation, or when the economy is experiencing a rapid expansion that can lead to high inflation. Easy money policy is implemented when the central bank decides to increase the flow of money to boost the economy, generally when it is experiencing a contraction. It includes lowering interest rates to make money cheaper to borrow.

Fiscal and monetary policy are the two instruments used by the state to influence the economical processes. Fiscal policy involves the government’s decisions on spending and taxes, and monetary policy refers to central bank activities mainly concerning interest rates. They both are used to control economic growth and regulate economic activity and can either influence one another or be implemented separately (Colander & Gamber, 2006). In terms of speed, flexibility, and effectiveness, the fiscal policy generally tends to be more effective, as it directly influences consumers. By increasing taxes and pulling money out of the economy, the given government can instantaneously slow down the business activity. In a recession, it can provide new jobs by paying for new investment schemes. Monetary policies implemented by a central bank take more time to come into effect. Fiscal policies have a direct influence on the market of goods, while monetary policies have a direct impact on the market of assets.


Colander, D., & Gamber, E. (2006). Macroeconomics. Pearson South Africa.

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