Question

“Fiscal policy is the government’s attempt to influence economy by setting and changing taxes, transfer payments and government expenditure on goods and services to influence the aggregate demand.” Discuss the effects of an in income taxes (contractionary fiscal policy) on the aggregate demand.

Answer 1

In contractionary fiscal policy taxes are increases , transfer payments reduced and government expenditure cut down to reduce quantity of money supply in the economy . Income taxes are increased during contractionary policy . Increase in income tax causes disposable income to fall . There is less money in the hands of people to spend on goods and services after paying high taxes . So their consumption demand declines . Decline in consumption demand is also followed by decline in investment as private savings fall after paying high taxes . So aggregate demand decreases in the economy . This policy is implied when there is inflationary pressures in the economy .