Fiscal and Monetary Policy Actions in the Short Run: Study Guide (Macroeconomics 5.1)

Two levers on one economy

In Units 3 and 4 you met two kinds of stabilization policy separately.

• Fiscal policy is run by the government. Its tools are government spending and taxes and transfers. A change in government spending changes AD directly. A change in taxes or transfers changes disposable income first, so it changes AD indirectly, through consumption.
• Monetary policy is run by the central bank. It changes interest rates. A central bank in a system with ample reserves moves its policy rate mainly by changing administered rates, such as the interest rate it pays on reserves. A central bank in a system with limited reserves changes the money supply through open market operations (and can use the discount rate and the required reserve ratio). Lower interest rates raise investment and interest-sensitive consumption; higher rates reduce them.

Real economies use both at once. This topic asks you to put them together: which combination closes a given output gap, and what the combination does to aggregate demand, real output, the price level and interest rates.

Choosing the direction: match the gap

The first step never changes. Find the gap, then push AD the opposite way.

Situation	Real GDP compared with full-employment output (Yf)	Fiscal action	Monetary action
Recessionary (negative) gap	Below Yf; unemployment above the natural rate	Expansionary: raise government spending, cut taxes or raise transfers	Expansionary: lower the policy rate (lower administered rates, or buy bonds in an open market purchase)
Inflationary (positive) gap	Above Yf; unemployment below the natural rate	Contractionary: cut government spending, raise taxes or cut transfers	Contractionary: raise the policy rate (raise administered rates, or sell bonds in an open market sale)

If both actions point the same way as the table, AD moves towards Yf. If one points the wrong way, the two policies are working against each other.

What a combined policy does

When both policies push the same way

Suppose both policies are expansionary. Each shifts AD to the right, so the shifts add up.

• AD increases.
• Real output increases and unemployment falls.
• The price level rises (along the upward-sloping SRAS curve).
• The nominal interest rate: uncertain. The monetary action lowers it. The fiscal action raises income and the price level, which raises the demand for money and pushes the interest rate up. Which effect is bigger depends on the sizes of the two actions.

With both policies contractionary, everything reverses: AD, real output and the price level fall, unemployment rises, and the interest rate effect is again uncertain.

When the policies push opposite ways

Now suppose the government cuts taxes (expansionary) while the central bank raises its policy rate (contractionary).

• The interest rate rises for certain. The central bank pushes it up, and the extra income from the tax cut raises money demand, which also pushes it up.
• The effect on AD, and so on real output and the price level, is uncertain. One policy shifts AD right and the other shifts it left; the net shift depends on their sizes.

The reverse mix (contractionary fiscal, expansionary monetary) gives a certain fall in the interest rate and an uncertain effect on AD.

Mix	AD, real output, price level	Nominal interest rate
Both expansionary	Increase	Uncertain
Both contractionary	Decrease	Uncertain
Expansionary fiscal + contractionary monetary	Uncertain	Increases
Contractionary fiscal + expansionary monetary	Uncertain	Decreases

A quick memory aid: same direction, certain AD; opposite directions, certain interest rate.

Our fictional economy: Valdoria

Valdoria is the fictional country used across the Marlbridge macroeconomics pages; its currency is the valda (VD). All data are fictional.

• Full-employment output: Yf = VD 840 billion. Natural rate of unemployment: 5.0%. Labour force: 25.0 million.
• Marginal propensity to consume (MPC): 0.75, so the spending multiplier is 1 ÷ 0.25 = 4 and the tax multiplier is −0.75 ÷ 0.25 = −3.
• A change in investment caused by a change in interest rates is multiplied by the spending multiplier, just like a change in government spending.

A note on the calculations. The multipliers give the size of the shift in AD. Because SRAS slopes upward, part of any AD shift raises the price level rather than output. That is why calculation questions ask for the minimum change needed: we treat an AD shift equal to the gap as the least that could close it.

Worked example 1: closing a recessionary gap with both policies

Question. Valdoria’s real GDP is VD 800 billion and unemployment is 6.0%. (a) Identify the gap and its size. (b) The government raises spending by VD 6 billion. Calculate the resulting shift in AD. (c) Calculate the minimum rise in investment that the central bank’s action must cause for the total AD shift to equal the gap, and state the monetary action. (d) Describe the effects of the combined policy on real output, unemployment, the price level and the nominal interest rate.

(a) Real GDP (800) is below Yf (840): a recessionary gap of 840 − 800 = VD 40 billion. Unemployment is 6.0 − 5.0 = 1.0 percentage point above the natural rate: 0.01 × 25.0 million = 0.25 million people are cyclically unemployed.

(b) Shift in AD = 4 × 6 = +VD 24 billion.

(c) The rest of the gap is 40 − 24 = VD 16 billion. Investment must rise by 16 ÷ 4 = VD 4 billion. The central bank should lower its policy rate: in an ample-reserves system by lowering the interest rate it pays on reserves; in a limited-reserves system by buying government bonds (an open market purchase).

(d) AD shifts right. Real output rises towards VD 840 billion, unemployment falls towards 5.0%, and the price level rises. The nominal interest rate is uncertain: the monetary action lowers it, but higher income raises money demand, which pushes it up.

Check. Using fiscal policy alone, the government would need a spending rise of 40 ÷ 4 = VD 10 billion, or a tax cut of 40 ÷ 3 = VD 13.33 billion. Sharing the work lets each policy make a smaller move.

Showing the interest rate on a money market graph

The AD–AS graph cannot show the interest rate, so use a money market graph alongside it. In the limited-reserves money market model, the money supply (MS) is vertical and money demand (MD) slopes down.

• Expansionary fiscal policy raises real output and the price level. People need more money for transactions, so MD shifts right and the nominal interest rate rises.
• Expansionary monetary policy (an open market purchase) shifts MS right and lowers the nominal interest rate.

With both at once, the result depends on the sizes. Figure 2 shows one important case: a central bank that wants to hold the interest rate steady while the government expands must increase the money supply by enough to offset the rise in money demand.

In an ample-reserves system the central bank does not need to change the money supply to hold its policy rate: it keeps its administered rates where it wants them. The direction of its choice (raise, hold or lower the policy rate) is what you analyse.

Worked example 2: cooling an inflationary gap, and a mixed policy

Question. A few years later, Valdoria’s real GDP is VD 880 billion and unemployment is 4.0%. The MPC is still 0.75. (a) Identify the gap and the direction of policy needed. (b) The central bank raises its policy rate, which reduces investment by VD 4 billion. Calculate the shift in AD. (c) Calculate the minimum tax increase that, together with the monetary action, would close the gap. What cut in government spending would do the same job? (d) Suppose instead the government cuts taxes by VD 4 billion at the same time as the rate rise. Calculate the net shift in AD and state the effect on the interest rate.

(a) Real GDP (880) is above Yf (840): an inflationary gap of VD 40 billion. AD must fall by VD 40 billion, so both policies should be contractionary.

(b) Shift in AD = 4 × (−4) = −VD 16 billion.

(c) AD must still fall by 40 − 16 = VD 24 billion. Tax increase = 24 ÷ 3 = VD 8 billion (tax multiplier −3: −3 × 8 = −24). A government spending cut of 24 ÷ 4 = VD 6 billion would do the same job. The tax rise must be larger than the spending cut because the tax multiplier is smaller: part of each valda of extra tax would have been saved, not spent.

(d) Monetary effect = −16. Tax cut effect = −3 × (−4) = +12. Net shift = −16 + 12 = −VD 4 billion. AD falls only slightly, so most of the inflationary gap remains. The interest rate rises for certain: the central bank raises it, and the tax cut adds to money demand.

Check. The two actions in (d) are both “VD 4 billion”, but they do not cancel. They have different multipliers (4 for investment, 3 for taxes), and the mix pulls in opposite directions. This is the opposite-direction case in the table: certain interest rate, uncertain (here small) change in AD.

Lags: why combining helps in practice

In reality both policies act with delays. Fiscal policy needs time to be agreed and put into effect. Monetary policy needs time for the problem to be recognised and for spending to respond to the new interest rates. Because the delays differ, using both levers, with smaller moves in each, can make the overall response less likely to overshoot.

Out of scope here. Long-run effects of these policies, such as how a deficit can raise the real interest rate and reduce private investment, come in Topics 5.4 and 5.5. Effects on exchange rates and net exports belong to Unit 6.

Common misconceptions

• “Expansionary fiscal and monetary policy together must lower interest rates.” No. The monetary action lowers the rate, but the fiscal action raises money demand. The net effect is uncertain.
• “A tax rise and an interest rate cut cancel out.” Their effects on AD may partly offset, but the interest rate falls for certain. Whether AD rises or falls depends on sizes.
• Adding the actions instead of their effects. Multiply each action by its own multiplier first, then add the shifts in AD.
• Using the spending multiplier for a tax change. A tax change uses the tax multiplier (−MPC ÷ MPS), which is smaller in size.
• Treating the AD shift as the change in real GDP. Part of the shift raises the price level; that is why calculations give the minimum action.
• Mixing up the gap and the policy. A recessionary gap needs expansionary policy; an inflationary gap needs contractionary policy. “Contractionary” describes the policy, not the economy.
• Drawing the interest rate on the AD–AS graph. Interest rates belong on a money market (or reserve market) graph; output and the price level belong on the AD–AS graph.

Where this leads

Next, Topic 5.2 shows the same short-run story on a new graph that plots inflation against unemployment: continue with the Phillips curve study guide. If the money market or the loanable funds market is not yet secure, go back to Topic 4.7 and the topics before it.

Now try the practice questions, then use the revision notes and the checklist to consolidate.