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Monetary and Fisical Policy

Categories: EconomicsPolicy

Chapter Outline:

  • The effects of fiscal and monetary policy on output
  • Monetary policy and the transmission mechanism
  • The liquidity trap
  • The classical case
  • The quantity theory of money
  • Fiscal policy and crowding out
  • Monetary accommodation
  • The effects of alternative policies on the composition of output
  • The U.S. economy in the 1980s and 1990s
  • Anticipatory monetary policy
  • The policy mix during the German re-unification

Changes from the Previous Edition:

The material in this chapter has been updated, but its format is essentially the same.

More emphasis is given to the economic expansion in the U.S. in the 1990s.

Introduction to the Material:

Chapter 11 uses the IS-LM model derived in Chapter 10 to show how monetary and fiscal policies can be used to dampen economic disturbances. The economic effects of various policy mixes are highlighted in discussions of actual events: the recession and recovery in the United States in the 1980s, the U.S. recession in 1990-91, the long economic expansion thereafter, and the policies enacted by Germany during the re-unification process in 1990-92.

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First, the Fed’s conduct of monetary policy is discussed, with an explanation of how open market operations can be used to change nominal money supply. The effectiveness of monetary policy in changing the amount of output demanded depends on the steepness of the LM-curve. The transmission mechanism, that is, the process by which monetary policy changes affect the economy, occurs in several steps. First, a change in money supply leads portfolio holders to make adjustments in their asset holdings.

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As a result, asset prices and interest rates change.

The change in interest rates subsequently affects intended spending and thus national income. Table 11-1 provides a summary of this process. Two extreme cases in the operation of monetary policy are given special attention. Monetary policy is powerless to affect interest rates (and thus the economy) in the liquidity trap (represented by a horizontal LM-curve). The polar opposite is the classical case (represented by a vertical LM-curve), in which a given change in money supply has the greatest effect on the level of income. The effectiveness of expansionary fiscal policy depends on the amount of crowding out that takes place, that is, on the reduction in private spending (most notably investment) caused by rising interest rates following fiscal expansion. It is important to state that crowding out is always a matter of degree.

When output is close to the full-employment level, any increase in aggregate demand due to fiscal expansion will be reflected mainly in an increase in interest rates and the price level, with little effect on the level of output. But when the economy experiences high unemployment, fiscal expansion can stimulate the economy successfully, without much upward pressure on interest rates or prices. Since Chapter 11 deals only with the IS-LM model, the extent of the crowding-out effect depends on the slopes of the IS- and LM-curves. The flatter the IS-curve and the steeper the LM-curve, the larger the crowding-out effect. (Special attention is again given to the two extremes of the liquidity trap and the classical case). The factors that determine the slopes of the IS- and LM-curves have already been discussed in the previous chapter. Here, some additional examples are given to emphasize the effects of fiscal policy changes on the composition of output, including the effects of investment subsidies.

While monetary and fiscal policy can both raise the level of output, their impacts on the composition of GDP can differ significantly. Monetary policy operates by affecting interest rates, which will first be felt by the most interest-sensitive sectors of the economy. In contrast, the effects of fiscal policy depend on which category of government expenditures and/or taxes are changed. Intended spending is affected first, but the impact on interest rates will modify the overall size of the multiplier effect. Since different monetary and fiscal policy mixes vary in their effects on the different sectors of the economy, actual policy choices are often determined by political preferences. Liberals often favor increases in government spending on education, job training, or the environment, while conservatives tend to favor tax cuts.

Those advocating rapid economic growth favor investment subsidies and lower interest rates. The economic policies implemented in the early 1980s differed greatly from those implemented in previous decades and serve as an excellent example of the effects of a tight monetary/expansionary fiscal policy mix. Monetary restriction in combination with fiscal expansion sharply increased interest rates. The Fed’s tight monetary policy caused the 1981/82 recession but successfully reduced the high inflation rate, whereas the administration’s expansionary fiscal policy drove the recovery after 1982.

For the rest of the 1980s, the Fed’s monetary policy succeeded in keeping the recovery going, but the fear of renewed inflation kept the Fed from lowering interest rates more rapidly in 1990 when early warning signs showed that the economy was headed for a recession. With Congress and the administration deadlocked over which fiscal policy measures to implement, it was up to the Fed to fight the recession. In an effort to stimulate the economy, the Fed repeatedly cut interest rates but, considering the long monetary policy lags, probably should have moved earlier and more aggressively.

After the 1990-91 recession, the U.S. economy experienced its longest peacetime expansion ever. The Fed and its chair Alan Greenspan deserve considerable credit for manipulating interest rates to allow continued economic expansion. The enormous growth rates of the late 1990s were attributed primarily to rapid technological growth, particularly due to investment in computer technology. Throughout this period, the Fed used prudent demand side management, always alert to the inflationary pressure that can build up as the economy grows too much. This anticipatory monetary policy became particularly evident in 2000, when the Fed raised interest rates several times after reports of very strong growth in late 1999.

While the political climate surrounding the re-unification of Germany was quite different from that in the U.S. in the early 1980s, the consequences of
Germany’s policy mix in the early 1990s closely resembled those of the early Reagan policies. Chancellor Kohl had promised that the German re-unification would not be financed by a tax increase. However, the German Bundesbank (one of the most anti-inflationary and independent central banks in the world), was unwilling to accommodate a massive increase in public spending with expansionary monetary policy. It is not surprising that, as a result of this restrictive monetary and expansionary fiscal policy mix, Germany experienced high real interest rates and a deficit in the current account of the balance of payments.

Suggestions for Lecturing:

Discussing actual events with which students should be at least somewhat familiar always makes the theoretical material come to life and gets students to participate more actively in class. The material presented in Chapter 11 about the economic policies implemented in the 1980s and early 1990s provides an excellent opportunity to show how various policy mixes affect income and the interest rate via the IS-LM framework. On the one hand, the discussion of real life events serves to show how well even a fairly simple model such as the IS-LM diagram can be used to predict the outcomes of various policy mixes. On the other hand, it also points out the limitations of the static, short-run nature of the model. References to aspects not incorporated in the model, such as international linkages and inflation should be included in classroom discussions.

While most instructors probably vividly remember the supply-side experiment under Reagan, they should realize that most of today’s students were borne after 1980 and know little, if anything, about economic events of that period. The same may be true for the recession of 1990-91 and the German re-unification. Thus it is extremely important to supplement the material in this chapter with examples of some more recent policy actions. When discussing monetary accommodation of expansionary fiscal policy, the following point should be made: Within an IS-LM framework, that is, as long as prices are assumed to be fixed, the Fed can prevent crowding out fairly easily by expanding money supply. However, as soon as prices are allowed to vary, such policy may lead to a higher price level.

In this case, crowding out cannot be avoided since a higher price level implies lower real money balances, which provide upward pressure on interest rates. It is also important that students understand why fiscal policy has a much smaller multiplier effect in the IS-LM model than in the simple Keynesian model of income determination that was presented in Chapter 9. In the IS-LM framework, the extent of crowding out clearly depends on the slopes of the IS- and LM-curves. Even though the factors determining these slopes are covered in Chapter 9, it may be beneficial to mention them here again. Instructors also may want to assign both Chapter 9 and Chapter 10, simultaneously, since Chapter 9 lays the theoretical framework for the IS-LM model, while Chapter 10 provides its practical application.

Since the IS- and LM-curves represent equilibrium conditions in the expenditure and money sectors, respectively, any change in slope must be the result of a structural change in one of the basic relationships used in formulating the models for these sectors. The classical case (the case of a vertical LM-curve, in which total crowding out occurs) and the liquidity trap (the case of a horizontal LM-curve, in which no crowding out occurs) are two extreme cases. Although it is unlikely that either case will ever occur, it is nonetheless useful to discuss them as they show students when fiscal or monetary policy either has a maximum effect or no effect at all on national income and interest rates.

In the discussion of the liquidity trap, instructors should mention that some economist believe that Japan may have been in (or close to) a liquidity trap in 1999. Students should be asked to work out several examples of either fiscal or monetary policy changes, both graphically and with a written explanation of the adjustment processes that take place.

In doing these exercises, students should ask themselves the following three questions:

  • Which sector is involved, the expenditure sector or the money sector? This will tell them which curve will shift, the IS-curve or the LM-curve.
  • Will the policy change lead to an increase or decrease in national income? This will tell them whether the respective curve will shift to the right or left.
  • Is it a parallel shift (caused by a change in autonomous spending or nominal money supply) or is it a change in the slope? The only policy change discussed here that could cause a change in slope is a change in the marginal income tax rate (t), which would change the size of the expenditure multiplier () and therefore the slope of the IS-curve.

Cite this page

Monetary and Fisical Policy. (2016, Oct 03). Retrieved from

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