Short on time? This page is the recap. For explanations, graphs and worked examples, use the full study guide.
Recap
- Fiscal policy (government): government spending changes AD directly; taxes and transfers change it indirectly, through disposable income and consumption.
- Monetary policy (central bank): changes the policy rate, by changing administered rates (ample reserves) or the money supply (limited reserves). Interest rates then change investment and consumption.
- To close a recessionary gap, use expansionary fiscal and monetary policy. To close an inflationary gap, use contractionary fiscal and monetary policy.
- A combined policy can influence AD, real output, the price level and interest rates.
Key relationships
| Mix | AD, real output, price level | Nominal interest rate |
|---|---|---|
| Both expansionary | Rise | Uncertain |
| Both contractionary | Fall | Uncertain |
| Expansionary fiscal + contractionary monetary | Uncertain | Rises |
| Contractionary fiscal + expansionary monetary | Uncertain | Falls |
| Calculation | Formula |
|---|---|
| Spending multiplier | 1 ÷ MPS |
| Tax multiplier | −MPC ÷ MPS |
| Shift from a change in G or in investment | spending multiplier × change |
| Shift from a change in taxes | tax multiplier × change in taxes |
| Combined shift in AD | fiscal shift + monetary shift |
Why the interest rate is uncertain when both expand: monetary policy lowers it, but higher income from fiscal expansion raises money demand and pushes it up.
Assumptions
- The multiplier gives the shift in AD. With upward-sloping SRAS some of it raises the price level, so calculated policy sizes are the minimum needed.
- A change in investment caused by interest rates uses the spending multiplier.
- Graphs: output and price level on AD–AS; the nominal interest rate on a money market (or reserve market) graph.
- Out of scope here: crowding out and the national debt (Topics 5.4–5.5); exchange-rate effects (Unit 6).
Mistakes to avoid
- Saying two expansionary policies must lower interest rates.
- Adding the actions (VD 6 billion + VD 4 billion) instead of their multiplied effects.
- Using the spending multiplier for a tax change.
- Assuming equal-sized opposite actions cancel out. They cancel only if they use the same multiplier (a tax cut and an investment fall do not).
- Calling a policy “recessionary”; gaps are recessionary or inflationary, policies are expansionary or contractionary.
Quick self-check
VD is the valda, the currency of the fictional country Valdoria used in the study guide.
- MPC = 0.8 and there is a recessionary gap of VD 50 billion. What is the minimum rise in government spending that closes it alone? (VD 10 billion)
- MPC = 0.75. The government cuts taxes by VD 3 billion. By how much does AD shift? (+VD 9 billion)
- Government spending rises by VD 5 billion and a rate rise cuts investment by VD 5 billion (MPC 0.75). Net shift in AD, and effect on the interest rate? (Zero; interest rate rises)
Next: practice questions.