Macroeconomics: Policy Mix

Fiscal and monetary policy

Goods and Money Market Equilibrium and the Real Economy

The Story So Far (Yet Again)

• 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.

Y = C + I + G + (X – M) . . . but this time, with monetary and fiscal policy.

There is a level of ouput or income (Y) and an interest rate (r) that represents an

equilibrium in both markets.





The Real EconomyBringing together the goods market and money market.

But First...

• 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.

How the goods and money markets are related.

Fiscal Policy

Monetary Policy

Expansionary

↑ G or ↓ T

↑ Money Supply

Contractionary

↓ G or ↑ T

↓ Money Supply

The Policy MixHow fiscal and monetary policies interact.

Fiscal Policy

Expansionary(↑ G or ↓ T )

Contractionary(↓ G or ↑ T)

Monetary

Policy

Expansionary(↑ Money Suppply)

Contractionary(↓ Money Suppply)

Case 1Expansionary Fiscal and Monetary Policies.

AE

Y

r

Ms

45º

Ms

Md

AE


AE

Y45º

AE

r

Ms

Ms

Md


AE

Y45º

r

Ms

Ms

Md

AE


AE

Y

r

Ms

45º

Ms

Md

AE


r

Ms

Ms

Md

AE

Y45º

AE


Fiscal Policy



Monetary

Policy


Y↑, AE↑, r?, I?


Case 2Contractionary Fiscal Policy and Expansionary Monetary Policy.

AE

Y45º

r

Ms

Ms

Md

AE


r

Ms

Ms

Md

AE

Y45º

AE


AE

Y45º

r

Ms

AE

Ms

Md


AE

Y

r

Ms

45º

Ms

Md

AE


Fiscal Policy



Monetary

Policy


Y↑, AE↑, r?, I? Y?, AE?, r↓, I↑


Case 3Expansionary Fiscal Policy and Contractionary Monetary Policy.

AE

Y

r

Ms

45º

Ms

Md

AE


AE

Y45º

r

Ms

Ms

Md

AE


AE

Y

r

Ms

45º

Ms

Md

AE


AE

Y

r

Ms

45º

Md

AE

Ms


AE

Y

r

Ms

45º

Md

Ms

AE


Fiscal Policy



Monetary

Policy


Y↑, AE↑, r?, I? Y?, AE?, r↓, I↑


Y?, AE?, r↑, I↓

Case 4Contractionary Fiscal and Monetary Policies.

AE

Y

r

Ms

45º

AE

Ms

Md


AE

Y

r

Ms

45º

Ms

Md

AE


AE

Y

r

Ms

45º

Md

AE

Ms


AE

Y

r

Ms

45º

Md

Ms

AE


Fiscal Policy



Monetary

Policy


Y↑, AE↑, r?, I? Y?, AE?, r↓, I↑


Y?, AE?, r↑, I↓ Y↓, AE↓, r?, I?







The Real EconomyBringing together the goods market and money market.

IS-LM AnalysisAnother way to depict goods and money market equilibrium.

r

Y

LM

IS

The LM Curve depicts various

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

for a given level of income.


Y

r

LM

IS

If both fiscal and monetary

policies are expansionary,

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.


r

Y

LM

IS

If monetary policy is

expansionary, the LM curve

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

each policy determines

what happens to Y and AE.

Macroeconomics: Policy Mix

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