The economy is going through a boom period with low unemployment and high inflation.
As shown in graph 1
Point A shows a boom phase
Where Y1 > Y0 i.e. Output is higher than potential
Also, P1 > P0 i.e. Price levels are high as well (inflation)
Contractionary fiscal policy is good to bring back economy to normal. Tools used can be G and T (G-Government spending, T-Taxes). In contractionary policy G decreases or T increases. This will shift AD left and will reduce Output.
Contractionary fiscal policy will help bring inflation back to normal. Tools used can be
2. policy rate
3. open market operation
For contractionary policy central bank may increase reserve requirement, may increase policy rate or may buy bonds in open market operations. All of this will reduce liquidity and inflation.
Graph 2 represents economy coming back to Normal O, after implementation of contractionary fiscal and monetary policies.
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