Which Best Explains How Contractionary Policies Can Hamper Economic Growth
Economic Growth and Contraction
Contractionary policies are government measures that reduce a country’s disposable income and therefore reduce economic growth. They are often implemented after periods of intense inflation and increased investment, and are intended to limit the distortions of the capital markets, such as excessive inflation caused by an expanding money supply and excessive asset prices, and crowding-out effects. However, such policies can also increase the unemployment rate and dampen economic growth.
Inflation is a gauge used by governments to determine whether an economy is overheating. Inflation above a certain target growth rate acts as a warning and triggers contractionary monetary policies. In the US, governments usually consider an annual inflation rate of two to three percent as normal. However, when inflation rises above this target rate, it is a signal to consumers that the economy is overheating and contractionary policies become necessary.
Contractionary fiscal policies reduce the economy’s disposable income and increase the deficit. These policies reduce GDP, increase unemployment, and reduce the volume of production. Ultimately, they slow down the economy and lead to destabilization and recession. In contrast, expansionary policies increase the money supply by reducing the income tax and increasing government spending.
Contractionary monetary policies are effective in slowing economic growth by reducing the amount of active money in an economy. The intention is to quell unsustainable capital investment and speculation. These measures are often implemented by raising the target federal funds rate, or the interest rate that banks charge each other overnight. Moreover, it helps meet reserve requirements and curbs inflation.
When an economy is beyond full employment, contractionary policies must be combined with expansionary policies. Inflation lowers demand for goods and services and reduces the purchasing power of pensioners. Inflation also depreciates a country’s currency. A combination of expansionary fiscal and monetary policies can boost economic growth. However, a country’s economic growth is limited by its ability to manage high levels of unemployment and inflation.
When monetary policy is aimed at increasing real income, the consumption of consumer goods increases. This in turn reduces the supply of loanable funds, which increases the interest rate. The decrease in net exports thereby decreases investment and increases consumer wealth. A contractionary policy can also reduce the number of jobs available to be created in an economy.
Inflationary policies can also hamper economic growth. An increase in interest rates can throw an economy into recession and depreciate the nation’s currency. Inflationary policies can also lead to increased unemployment and lower productivity. The goal of an economy is to minimize unemployment and improve productivity.