Fiscal and monetary policy

Goods and Money Market Equilibrium and the Real Economy

The Story So Far (Yet Again)
Y = C + I + G + (X – M) . . . but this time, with monetary and fiscal policy.

• We know that the economy is in equilibrium when Y = AE.

• There is a level of output for which income is equal to

planned aggregate expenditure.

• The components of planned aggregate expenditure are

consumption, investment, and government spending.

• Fiscal policy involves control over government spending

and taxation, which has an effect on Y in the goods market.

• Monetary policy involves control over the money supply,

which has an effect on r in the money market.
The Real Economy
Bringing together the goods market and money market.

There is a level of ouput or income (Y) and

an interest rate (r) that represents an
equilibrium in both markets.
But First...
How the goods and money markets are related.

• The goods and money markets are related as follows:

• The goods market determines income, which affects the

demand for money.

• The money market determines the interest rate, which

affects the level of investment.

• Government policies toward the goods and money markets

can be either expansionary or contractionary.

Expansionary Contractionary
Fiscal Policy ↑ G or ↓ T ↓ G or ↑ T
Monetary Policy ↑ Money Supply ↓ Money Supply
 The Policy Mix
How fiscal and monetary policies interact.

Fiscal Policy

Expansionary Contractionary
(↑ G or ↓ T ) (↓ G or ↑ T)

Expansionary
(↑ Money Suppply)
Monetary
Policy
Contractionary
(↓ Money Suppply)
 Case 1
Expansionary Fiscal and Monetary Policies.

AE r s
M

AE

d
M

45º
s
Y M
 Case 1
Expansionary Fiscal and Monetary Policies.

AE r s
M

AE

d
M

45º
s
Y M
 Case 1
Expansionary Fiscal and Monetary Policies.

AE r s
M

AE

d
M
45º
s
Y M
 Case 1
Expansionary Fiscal and Monetary Policies.

AE r s
M

AE

d
M
45º
s
Y M
 Case 1
Expansionary Fiscal and Monetary Policies.

AE r s
M

AE

d
M

45º
s
Y M
 Case 1
Expansionary Fiscal and Monetary Policies.

AE r s
M

AE

d
M

45º
s
Y M
 Case 1
Expansionary Fiscal and Monetary Policies.

AE r s
M

AE

d
M

45º
s
Y M
 The Policy Mix
How fiscal and monetary policies interact.

Fiscal Policy

Expansionary Contractionary
(↑ G or ↓ T ) (↓ G or ↑ T)

Expansionary Y↑, AE↑, r?, I?

(↑ Money Suppply)
Monetary
Policy
Contractionary
(↓ Money Suppply)
 Case 2
Contractionary Fiscal Policy and Expansionary Monetary Policy.

AE r s
M

AE

d
M

45º
s
Y M
 Case 2
Contractionary Fiscal Policy and Expansionary Monetary Policy.

AE r s
M

AE

d
M

45º
s
Y M
 Case 2
Contractionary Fiscal Policy and Expansionary Monetary Policy.

AE r s
M
AE

d
M

45º
s
Y M
 Case 2
Contractionary Fiscal Policy and Expansionary Monetary Policy.

AE r s
M
AE

d
M
45º
s
Y M
 Case 2
Contractionary Fiscal Policy and Expansionary Monetary Policy.

AE r s
M

AE

d
M

45º
s
Y M
 Case 2
Contractionary Fiscal Policy and Expansionary Monetary Policy.

AE r s
M

AE
d
M

45º
s
Y M
 Case 2
Contractionary Fiscal Policy and Expansionary Monetary Policy.

AE r s
M

AE

d
M
45º
s
Y M
 Case 2
Contractionary Fiscal Policy and Expansionary Monetary Policy.

AE r s
M

AE

d
M
45º
s
Y M
 The Policy Mix
How fiscal and monetary policies interact.

Fiscal Policy

Expansionary Contractionary
(↑ G or ↓ T ) (↓ G or ↑ T)

Expansionary Y↑, AE↑, r?, I? Y?, AE?, r↓, I↑

(↑ Money Suppply)
Monetary
Policy
Contractionary
(↓ Money Suppply)
 Case 3
Expansionary Fiscal Policy and Contractionary Monetary Policy.

AE r s
M

AE

d
M

45º
s
Y M
 Case 3
Expansionary Fiscal Policy and Contractionary Monetary Policy.

AE r s
M
AE

d
M

45º
s
Y M
 Case 3
Expansionary Fiscal Policy and Contractionary Monetary Policy.

AE r s
M
AE

d
M
45º
s
Y M
 Case 3
Expansionary Fiscal Policy and Contractionary Monetary Policy.

AE r s
M

AE

d
M
45º
s
Y M
 Case 3
Expansionary Fiscal Policy and Contractionary Monetary Policy.

AE r s
M

AE

d
M

45º
s
Y M
 Case 3
Expansionary Fiscal Policy and Contractionary Monetary Policy.

AE r s
M

AE

d
M

45º
s
Y M
 Case 3
Expansionary Fiscal Policy and Contractionary Monetary Policy.

AE r s
M

AE

d
M

45º
s
Y M
 Case 3
Expansionary Fiscal Policy and Contractionary Monetary Policy.

AE r s
M

AE

d
M
45º
s
Y M
 Case 3
Expansionary Fiscal Policy and Contractionary Monetary Policy.

AE r s
M

AE

d
M
45º
s
Y M
 The Policy Mix
How fiscal and monetary policies interact.

Fiscal Policy

Expansionary Contractionary
(↑ G or ↓ T ) (↓ G or ↑ T)

Expansionary Y↑, AE↑, r?, I? Y?, AE?, r↓, I↑

(↑ Money Suppply)
Monetary
Policy
Contractionary Y?, AE?, r↑, I↓
(↓ Money Suppply)
 Case 4
Contractionary Fiscal and Monetary Policies.

AE r s
M

AE

d
M

45º
s
Y M
 Case 4
Contractionary Fiscal and Monetary Policies.

AE r s
M

AE
d
M

45º
s
Y M
 Case 4
Contractionary Fiscal and Monetary Policies.

AE r s
M

AE

d
M
45º
s
Y M
 Case 4
Contractionary Fiscal and Monetary Policies.

AE r s
M

AE

d
M
45º
s
Y M
 Case 4
Contractionary Fiscal and Monetary Policies.

AE r s
M

AE

d
M

45º
s
Y M
 Case 4
Contractionary Fiscal and Monetary Policies.

AE r s
M

AE

d
M

45º
s
Y M
 Case 4
Contractionary Fiscal and Monetary Policies.

AE r s
M

AE

d
M

45º
s
Y M
 Case 4
Contractionary Fiscal and Monetary Policies.

AE r s
M

AE

d
M
45º
s
Y M
 Case 4
Contractionary Fiscal and Monetary Policies.

AE r s
M

AE

d
M
45º
s
Y M
 The Policy Mix
How fiscal and monetary policies interact.

Fiscal Policy

Expansionary Contractionary
(↑ G or ↓ T ) (↓ G or ↑ T)

Expansionary Y↑, AE↑, r?, I? Y?, AE?, r↓, I↑

(↑ Money Suppply)
Monetary
Policy
Contractionary Y?, AE?, r↑, I↓ Y↓, AE↓, r?, I?
(↓ Money Suppply)
The Real Economy
Bringing together the goods market and money market.

There is a level of ouput or income (Y) and

an interest rate (r) that represents an
equilibrium in both markets.
 IS-LM Analysis
Another way to depict goods and money market equilibrium.

r The LM Curve depicts various

LM interest rates at which the
money market is in equilibrium
for a given level of income.

The IS Curve depicts various

interest rates at which the
goods market is in equilibrium
IS for a given level of income.

Y
 IS-LM Analysis
Another way to depict goods and money market equilibrium.

r If both fiscal and monetary

policies are expansionary,
LM output clearly increases.
Presumably so does AE.

However, we cannot say

what happens to the interest
rate or investment without
knowing the relative
magnitude of each policy.

IS
Y
 IS-LM Analysis
Another way to depict goods and money market equilibrium.

If monetary policy is
r expansionary, the LM curve
LM shifts outward.
If fiscal policy is
contractionary, the IS curve
shifts inward.
The interest rate declines,
meaning that investments
must rise.
The relative magnitude of
IS each policy determines
what happens to Y and AE.
Y