Any government policy that is aimed at reducing aggregate output (income) (Y) is said to be contractionary. Where the expansionary policy is used to boost the economy, the contractionary policy is used to slow the economy.
Why the government would adopt policies designed to reduce aggregate spending? One way to fight inflation is to reduce aggregate spending. When the inflation rate is high, the government may feel compelled to use its powers to contract the economy.
Contractionary Fiscal Policy: A Decrease in Government Spending (G) or an Increase in Net Taxes (T)
~Contractionary fiscal policy is a decrease in government spending (G) or an increase in net taxes (T) aimed at decreasing aggregate output (income) (Y). the effects of this policy are the opposite of the effects of the expansionary fiscal policy.
~A decrease in government purchases or an increase in the net taxes leads to a decrease in aggregate output, a decrease in the demand for money (Md) and a decrease in the interest rates (r). The decrease in Y that accompanies a contractionary fiscal policy is less than it would be if we did not take the money market into the account because the decrease in r also causes planned investment (I) to increase.
~This increase in I offsets some of the decreases in planned aggregate expenditure brought about by the decrease in G. (this also means the multiplier effect is smaller than it would be if we did not take the money market into account).
Contractionary Monetary Policy: A decrease in the Monetary Supply
~A contractionary monetary policy is a decrease in the money supply aimed at decreasing aggregate output (income) (Y). the level of planned investment spending is a negative function of the interest rate. The higher the interest rate, the less planned investment there will be.
~ The less planned investment there is, the lower planned aggregate expenditure there will be, and the lower the equilibrium level of output will be.
~The lower equilibrium income results in a decrease in the demand for money, which means that the increase in the interest rate will be less than it would be if we did not take the goods market into account.