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Lesson summary: Fiscal and monetary policy actions in the short run

AP.MACRO:
POL‑1 (EU)
,
POL‑1.F (LO)
,
POL‑1.F.1 (EK)
,
POL‑1.F.2 (EK)
In this lesson summary review and remind yourself of the key terms and graphs related to the effects of fiscal policy actions in the short run. Topics include how fiscal and monetary policy can be used in combination to close output gaps, and how fiscal and monetary policy affect key macroeconomic indicators such as output, unemployment, the real interest rate, and inflation.

Summary

In the last unit, we learned that either fiscal policy or monetary policy could be used to close output gaps. As it turns out, we aren’t bound to have one or the other! A combination of these policies can be used to restore an economy to full employment output. Perhaps even more intriguing is the possibility that these actions might not be coordinated, and the result might be fiscal policy and monetary policy working against each other.

Key terms

Key termdefinition
Central bank autonomythe idea that a central bank should be an independent government entity that operates without influence from other parts of a government; for example, the Federal Reserve Bank of the United States is ultimately accountable to the citizens and Congress, but is an independent agency within the government that Congress cannot directly control.

A combination of fiscal and monetary policies can be used to restore an economy to full employment

Fiscal and monetary policies are frequently used together to restore an economy to full employment output. For example, suppose an economy is experiencing a severe recession. One possible solution would be to engage in expansionary fiscal policy to increase aggregate demand. The central bank can also do its part by engaging in expansionary monetary policy.
On the other hand, we can’t assume that the government and the central bank will always see eye-to-eye on the economy, and it is possible that these two entities work against each other. For example, suppose a government wants to increase output and decrease unemployment by increasing government spending. If the economy is operating on an upward-sloping aggregate supply curve (in other words, if prices are sticky), then this is also going to lead to inflation.
Recall that most central banks operate under a dual mandate to encourage full employment and control inflation. If the central bank believes that the unemployment rate is lower than the natural rate of unemployment and there is inflation, it might take action to counteract what the government is doing to control inflation. For example, if the government engages in expansionary fiscal policy that leads to inflation, the central bank might decrease the money supply to lower inflation.

Fiscal and monetary policy can impact output, inflation, unemployment, and interest rates

We know from previous lessons that monetary and fiscal policies can influence output, inflation, the unemployment rate, and interest rates. We can summarize the short-run impact of different combinations of fiscal and monetary policy as shown in the table below:
Expansionary monetary policy (open market purchases)Contractionary monetary policy (open market sales)
Expansionary fiscal policy (increase government spending/decrease taxes)G and/or C ADMSiADOutputURPLG \text{ and/or C }\uparrow \rightarrow AD \uparrow \\ MS \uparrow i \downarrow \rightarrow AD \uparrow \\ \text{Output} \uparrow UR \downarrow PL \uparrowG and/or CADMSiADOutput ? UR ? PL ? G \text{ and/or }C \uparrow \rightarrow AD \uparrow \\ MS \downarrow i \uparrow \rightarrow AD\downarrow \\ \text{Output ? UR ? PL ? }
Contractionary fiscal policy (decrease government spending/increase taxes) G and/or C ADMSiADOutput ? UR ? PL ?\text{ G and/or C }\downarrow \rightarrow AD \downarrow \\ MS \uparrow i\uparrow \rightarrow AD \uparrow \\ \text{Output ? UR ? PL ?}G and/or C ADMSiADOutput URPLG\text{ and/or C }\downarrow \rightarrow AD \downarrow \\\\ MS \downarrow i \uparrow \rightarrow AD \downarrow \\ \text{Output }\downarrow UR \uparrow PL \downarrow

Monetary policy can be used to mitigate the impact of fiscal policy on interest rates

Recall that the relationship between nominal and real interest rates is:
start text, N, o, m, i, n, a, l, space, i, n, t, e, r, e, s, t, space, r, a, t, e, end text, equals, start text, r, e, a, l, space, i, n, t, e, r, e, s, t, space, r, a, t, e, end text, plus, start text, e, x, p, e, c, t, e, d, space, i, n, f, l, a, t, i, o, n, end text
For example, suppose that initially the real interest rate is 4% and the expected rate of inflation is 2%, resulting in a nominal interest rate of 6%:
Nominal interest rate=real interest rate+expected inflation=4%+2%=6%\begin{aligned}\text{Nominal interest rate} &= \text{real interest rate} + \text{expected inflation} \\\\ &= 4\%+2\%\\\\ &=6\%\end{aligned}
Now, suppose that a government increased its spending. This expansionary fiscal policy would increase aggregate demand, which leads to more output, a lower rate of unemployment, and higher inflation. If people adjust their expectations, and expected inflation increases from 2% to 5%, then the nominal interest rate becomes:
nominal interest rate=real interest rate+expected inflation=4%+5%=9%\begin{aligned} \text{nominal interest rate} &=\text{real interest rate} + \text{expected inflation}\\\\ &= 4\%+5\%\\\\ &=9\%\end{aligned}
Uh-oh! An increase in interest rates might undo some of the intended effects of the expansionary fiscal policy–so the central bank might simultaneously engage in expansionary monetary policy to lower the nominal interest rate back to its initial level.

Common misperceptions

Many new learners incorrectly assume that because central banks operate in an official capacity, they will always take the same action as a government when it comes to policy. This is incorrect because most central banks have the autonomy to conduct operations that are in line with their mandate, which frees them to operate without political pressures such as election cycles.

Questions for review

  1. What combination of monetary and fiscal policies would be appropriate if both the government and the central bank were concerned about high rates of unemployment? Give at least two examples of each type of policy.
  2. If a government increases government spending and decreases taxes, what actions could a central bank take to keep nominal interest rates stable? Explain.
  3. If a central bank was concerned that a government's fiscal policy actions could potentially cause inflation, and the bank wanted to stop that inflation, what steps might the central bank take to offset the government’s efforts? Explain.

Want to join the conversation?

  • leafers seedling style avatar for user Chahak Gupta
    In the box for contractionary fiscal policy and expansionary monetary policy, why does an increase in money supply cause an increase in interest rates? Is that a typo?
    (2 votes)
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  • blobby green style avatar for user tahminatisha24
    Describe the outcome in the short-run if governments choose not to take fiscal policy action in a recession?
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  • blobby green style avatar for user Bonnie
    Explain the chain of events that occurs for expansionary and contractionary monetary policy to affect the long-run equilibrium level of real gross domestic product
    (1 vote)
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  • aqualine ultimate style avatar for user Diyorahon Rakhimova
    - How would I label a Contractionary Monetary Policy on an AS/AD graph?
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  • blobby green style avatar for user Prime, Vann
    Are you certain that most central banks target both inflation and unemployment? I believe most central banks only target inflation. It's the Fed that's saddled with the dual mandate.
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  • blobby green style avatar for user salmanss6116421
    sir..is the effectiveness of fiscal policy depend on slope of IS curve in IS-LM model?graphically explain?please answer me sir
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  • blobby green style avatar for user Danaalkhateeb
    If the government implements an expansionary fiscal policy, what action can the central bank take to maintain a stable interest rate?
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  • leaf green style avatar for user prathambabaria2
    Can a combination of fiscal and monetary policy be used to combat high unemployment and inflation?
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  • leaf yellow style avatar for user [Au]^79
    In the previous video, Sal said that money supply and interest rates are inversely proportional. what's the difference here?
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  • piceratops seed style avatar for user ah419067
    if Congress conducts Fiscal Policy and the economy is in a recession, what should change on the Loanable Funds Graph
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