Fiscal policy is the government's attempt to influence the economy by setting and changing taxes, government spending, deficits and public debt (Matthews et al 2003 ). Contractionary fiscal policy is, therefore, a policy in which a decrease in government spending, an increase in taxes plus a decrease in transfers are applied to mitigate inflationary problems that arise during an expansion of the business cycle. Therefore, it slows down the economy, decreases the inflation rate and closes the inflation gap. This essay will examine the extent of this policy's contribution to the decline in economic activity. Consequently, it will analyze the effects on economic activity according to Keynesian theory, “classical” theory and the Mundell-Fleming model. Furthermore, comments will be provided on the results of an empirical study under a fixed exchange rate regime of the Obstfeld and Rogoff model and will be compared with other theories and models. Contractionary fiscal policy, which is a reduction of the budget deficit, works through government spending and taxes. However, it is easier to separate them into three instruments, namely government purchases, taxes and transfers, to see their effect on economic activity in the short, medium and long run. Government purchases are public expenditures, undertaken by government agencies, on final goods and services or on the gross domestic product of an economy. These include small items such as paper clips, office furniture, and teacher salaries for highway construction. Therefore, restrictive fiscal policy will result in a cut in funds allocated to various agents, thus reducing aggregate production, income and inflation rates. As a result, this policy is… halfway through the paper… licy.Works CitedAmosWeb (2012) Restrictive fiscal policy. [online] Available at: http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=contractionary+fiscal+policy [Accessed: 10 March 2012].Blanchard, O. (2011) Macroeconomics. 5th ed. Massachusetts: Pearson.Casella, P. (2001) Fiscal consolidation under fixed exchange rates. European Economic Review, 45 (3), p.425-450. Giavazzi, F. and Pagano, M. (1990) Can severe fiscal contractions be expansionary? Stories of two small European countries. NBER Macroeconomics Annual, 5 p.75-110.Matthews, K. et al. (2003) Economy. 5th ed. Edinburgh: Pearson.Rossana, R. (2011) Macroeconomics. New York NY: Routledge.Saint-Paul, G. (1993) Productivity growth and the structure of the business cycle. European Economic Review, 37 (4), p.861-883. Sloman, J. and Wride, A. (2009) Economics. 7th ed. Edinburgh: Pearson.