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The analogy of the balloon

To help imagine how these policies work, think of the economy as a balloon. The air in the balloon is the level of demand or economic activity. If the balloon is a little low and short of air, you want to reflate it; if it is over-expanded and in danger of bursting, then you deflate it.

This is similar to the economy. However, when an economy over-expands, instead of bursting, it suffers from other problems including higher inflation and a deteriorating balance of payments. Supply-side policies are policies that manage the capacity of the balloon: making it bigger so it can take more air or making the balloon material more 'stretchy', so it can expand further.


Contractionary Policies (Reducing aggregate demand)

Tight Fiscal Policy

  • reducing governments spending
  • Increasing taxation

Tight Monetary Policy

  • Increase interest rates
  • Reduce money supply


Expansionary Policies (Increasing Aggregate Demand)

Loose Fiscal Policy

  • increasing government spending
  • reducing taxation

Loose monetary policy

  • decreasing interest rates
  • increasing the money supply