5.1 - Fiscal and Monetary Policy Actions in the Short Run
Reviewing Stabilization Policy
Policymakers try to smooth out the business cycle.
- Recessionary gap (Y < YP): needs expansionary policy.
- Fiscal: cut taxes, raise spending, or increase transfers.
- Monetary: the Fed expands the money supply and lowers rates.
- Both shift AD right, pushing the economy back to potential output and the natural rate of unemployment.
- Inflationary gap (Y > YP): needs contractionary policy, which shifts AD left.
- Fiscal: raise taxes, cut spending, or reduce transfers.
- Monetary: the Fed shrinks the money supply and raises rates (for example, by selling bonds or raising its administered rates).
- Both shift AD left, bringing the economy back to potential output and the natural rate of unemployment with less inflation.
Fiscal and monetary policy can be used one at a time or together. Either way, the goal is the same: close the output gap and bring the economy back to full employment.
Effects on Interest Rates and Bond Prices
Since interest rates and bond prices move opposite each other, that’s the key thing to track.
Monetary policy works through the money market directly:
- Expansionary monetary policy shifts money supply right, lowering rates, which raises investment and spending (AD shifts right). Lower rates mean higher bond prices.
- Contractionary monetary policy shifts money supply left, raising rates and lowering bond prices.
Fiscal policy works indirectly, by changing output and prices first, which then shifts money demand:
- Expansionary fiscal policy shifts AD right, raising both the price level and real output. Since money demand rises with both P and Y, MD shifts right too, which raises the nominal rate and lowers bond prices. (The money supply itself isn’t affected, since only the Fed controls that.)
- Contractionary fiscal policy shifts AD left, lowering P and Y, which reduces money demand, lowers the nominal rate, and raises bond prices.
Combining Policies
Analyze each policy separately, then compare:
- Both expansionary: AD, P, and Y all rise. But the effect on interest rates is unclear, since monetary policy pushes rates down while fiscal policy pushes them up. This combo is useful if you want to boost output while keeping rates relatively steady.
- Both contractionary: AD, P, and Y all fall. The effect on interest rates is unclear again, since monetary policy pushes rates up while fiscal policy lowers money demand and pushes rates down.
- One expansionary, one contractionary: the effect on interest rates becomes clear (since both moves push rates the same direction), but the effect on AD, Y, and P becomes unclear.
- Expansionary fiscal + contractionary monetary: interest rates definitely rise (fiscal policy raises money demand while the Fed shrinks the money supply), and bond prices fall.
- Contractionary fiscal + expansionary monetary: interest rates definitely fall, and bond prices rise. This mix is one way to shrink a budget deficit without causing a recession: the spending cuts or tax increases pull AD left, while the lower rates boost investment and push AD back right.
Here’s the whole picture. “Indeterminate” means the two policies push that variable in opposite directions, so the result depends on which policy is stronger. If a question doesn’t tell you, that’s the answer.
Policy mix | AD, real output, and price level | Interest rate | Bond prices |
Expansionary fiscal + expansionary monetary | Increase | Indeterminate | Indeterminate |
Contractionary fiscal + contractionary monetary | Decrease | Indeterminate | Indeterminate |
Expansionary fiscal + contractionary monetary | Indeterminate | Increase | Decrease |
Contractionary fiscal + expansionary monetary | Indeterminate | Decrease | Increase |
Example: the economy is in a recessionary gap, so Congress raises government spending and the Fed buys bonds. On the AD-AS graph, both policies shift AD right, so real output and the price level rise toward potential output. On the money market graph, the Fed’s bond purchases shift MS right (pushing the nominal interest rate down), while the higher price level and output shift MD right (pushing it up). So the nominal interest rate is indeterminate.
Bottom line: both fiscal and monetary policy aim to shift AD and stabilize the economy. Monetary policy works directly on the money supply and rates; fiscal policy works indirectly through prices and output, which then shifts money demand. When combined in the same direction, the output effect is certain but the rate effect can go either way.