12 MONETARY AND FISCAL POLICY

FOCUS OF THE CHAPTER

• This chapter uses the IS-LM model to look at the ways that fiscal and monetary policy can be
used to stabilize the economy. We find that the effectiveness of monetary and fiscal policy
depend on the slopes of the IS and LM curves.

• The combination of fiscal and monetary policy in an economy determines both the composition
of output and the position of the AD curve.

SECTION SUMMARIES

1. Monetary Policy
The central bank conducts monetary policy by engaging in open market operations⎯by buying
and selling bonds. When the Fed sells bonds, it reduces the money supply. People send money
to the central bank, which it takes out of circulation; in return, they receive a piece of paper they
cannot spend. When the Fed buys bonds, it increases the money supply: people exchange those
pieces of paper for money.

An increase in the money supply does not initially affect people’s disposable income, or the
autonomous component of AD; its initial effect is to lower the interest rate. Because this raises
the level of investment without reducing consumption or government spending, aggregate
demand then increases. Figure 12–1 uses an IS-LM diagram to show the short-run effect of a
monetary expansion.

Monetary policy is most effective when the LM curve is relatively steep, or when the demand for
real money balances is not very sensitive to the interest rate (the parameter h in the money
demand equation is small). It is also more effective when investment is highly sensitive to

123
124 CHAPTER 12

LM

LM’
i0 *
i2 * P

i1 IS
P AS

AD’

Y
AD

Y0 * Y2 * Y0* Y2* Y

Figure 12−1
A MONETARY EXPANSION LOWERS THE INTEREST RATE, SHIFTING THE AD CURVE OUTWARD .

changes in the interest rate (the parameter b in the investment function is large), and when the
marginal propensity to consume is small⎯i.e., when the IS curve is relatively flat.

There are two polar cases that have received a lot of attention: The first, called a liquidity trap,
occurs when people are willing to hold as much money as is supplied (when the money demand
curve is horizontal, so that an increase in the supply of real money balances does not affect the
interest rate). When the economy is in a liquidity trap, the LM curve is perfectly flat, and changes
in the supply of money do not cause it to shift. Because the interest rate does not change,
investment demand remains constant, and the level of aggregate demand is not affected.

The second⎯the classical case⎯occurs when the LM curve is vertical, or when the demand for
money is not a function of the interest rate. In this instance, monetary policy is most effective,
and fiscal policy cannot affect the level of output at all.

2. The Zero Lower Bound and Unorthodox Monetary Policy

Interest rates cannot go below zero because, if they did, then investors would be better off by
simply holding cash. This lower limit on interest rates is called the zero lower bound or ZLB. The
zero lower bound effectively puts a limit on how far monetary policy can go. When does this
limit come into play? When both nominal interest rates are low and there is a need for
expansionary monetary policy. When interest rates reach the ZLB, the Fed can turn to alternative
tools, which we call “unorthodox” policies.
 MONETARY AND FISCAL POLICY 125

During the 2007–2009 Great Recession, nominal interest rates in the United States effectively hit
the zero lower bound so there was no further scope for conventional open market operations.
Because of the crisis, the Fed undertook a policy of massive quantitative easing. Quantitative
easing is a strategy of buying up large quantities of financial assets when the short-term interest
rate is zero in order to reduce long-term interest rates. To this end, the Fed not only bought
Treasury securities, it also bought a variety of other kinds of debts of U.S. government agencies
and massive amounts of securities backed by private mortgages. One reason why quantitative
easing is unorthodox and not typically used by the Fed is that it requires a very large volume
intervention. The supply of long-term financial assets is so large that an increase in demand by
the Fed must be very sizeable in order to move the equilibrium price even a little bit.

3. Fiscal Policy and Crowding Out

A fiscal expansion⎯a decrease in taxes, or an increase in either government spending or
transfers⎯directly increases AD, although by less than we might initially expect. An increase in
autonomous demand makes people want to hold more money at any given interest rate, shifting
the IS curve outward. This increase in money demand, however, drives up the interest rate,
which, in turn, reduces the level of investment. One force acts to increase AD; the other pushes
back, preventing it from increasing as much as otherwise it would. Figure 12–2 illustrates this.
When a fiscal expansion increases the interest rate and, therefore, reduces investment demand,

i P

LM

i 2*
i 0*
P AS
IS’
AD’
IS
AD

Y0* Y2* Y1 Y Y0* Y2* Y1 Y

Figure 12–2
A FISCAL EXPANSION RAISES THE INTEREST RATE, CROWDING OUT INVESTMENT.
THE AD CURVE SHIFTS OUTWARD , BUT NOT BY AS MUCH AS IT COULD.
i P

LM

i na LM”
i 0*
P AS
IS’
AD’
IS
AD

Y0* Yna Y1* Y Y0* Yna Y1* Y

Figure 12–3
MONETARY ACCOMMODATION PREVENTS CROWDING OUT.
THE AD CURVE SHIFTS OUTWARD BY THE FULL AMOUNT.

we say there is crowding out. In the classical case (when the LM curve is vertical) there is full
crowding out⎯any increase in autonomous spending raises interest rates so much that the
corresponding fall in investment prevents AD from increasing at all. Fiscal policy has no effect
on output.

There is no crowding out when the economy is in a liquidity trap; an increase in autonomous
spending has no effect on the interest rate, and thus no impact on investment. There also need
not be any crowding out if the central bank accommodates a fiscal expansion by increasing the
money supply enough to keep the interest rate at its current level. When the central bank
accommodates a fiscal expansion, we also say that they are monetizing the budget deficit: it uses
some of the money it has taken out of circulation to buy the bonds that the federal government
uses to finance its deficit. Figure 12−3 provides an example.

4. The Composition of Output and the Policy Mix

Either fiscal policy or monetary policy can be used to expand aggregate demand. Expansionary
fiscal policy, however, discourages investment, while expansionary monetary policy encourages
it. Different methods of fiscal expansion affect the composition of output differently. The choice
of policy mix⎯particularly the choice between spending and tax policy⎯can be made in such a
way that other political objectives are accomplished. It is an issue of political economy.

5. The Policy Mix in Action

This section provides several historical examples of the ways that the policy mix decision has
been made in the real world. It discusses the combination of loose (expansionary) fiscal policy
with tight (contractionary) monetary policy in the 1980s, and highlights the central bank’s ability
to combat anticipated as well as existing problems. The loose monetary policy and tight fiscal

126
 MONETARY AND FISCAL POLICY 127

policy mix is also discussed in using the 1991 recession in the U.S. as a case study. The response
to 2001 recession in the U.S. has been a mix of tax cut (the fiscal policy boost) and a sharp drop of
interest rates (the monetary policy response). Finally, the policy response to the Great Recession,
that ended in June, 2009, was also a fiscal policy boost (both tax cut and fiscal spending increase)
and a lowering of interest rates to near zero levels. The connection between the policy and the
current or anticipated inflation has also been explored. We are reminded of the difference
between real and nominal interest rates: The real rate is roughly equal to the nominal rate minus
the rate of inflation.

KEY TERMS

open market operations monetary accommodation

transmission mechanism monetizing budget deficits
portfolio disequilibrium investment subsidy
liquidity trap investment tax credit
classical case quantitative easing
quantity theory of money zero lower bound (ZLB)
crowding out

GRAPH IT 12

Does tight monetary policy put people out of work? Or does the monetary policy respond
counter-cyclically to high unemployment? You might think that we could answer such a
question by simply graphing the unemployment rate against the level of real money balances.
This would, of course, be a dangerous way to answer a scientific question; it ignores the influence
of fiscal policy on unemployment. As monetary policy seems to have been dominant in recent
years, however, we’ll throw caution to the winds and do it anyway.

Table 12–1 provides data on the level of unemployment, the nominal money supply, and the
price level for the years 1990–2012. You will have to calculate the level of real money balances by
hand. This isn’t so bad; it just involves dividing some measure of the nominal money supply (we
use M1) by another measure of the price level (we use the CPI). After you have calculated the
level of real money balances, you should plot the rate of unemployment against it for each year in
the sample. We’ve plotted the first three data points to get you started (see Table 12–1 and Chart
12–1). You do the rest. Does it look like an increase in the real money supply will reduce the rate
of unemployment? (If you “fit” a line to the points you have drawn, would it slope downward?
If so, your answer should imply tight monetary policy is associated with high unemployment.)
128 CHAPTER 12

TABLE 12–1

Year Unemployment M1 CPI Real Money Balances

1990 5.6 810.6 130.7 6.2

1991 6.9 859.0 136.2 6.3

1992 7.5 965.9 140.3 6.9

1993 6.9 1078.4 144.5

1994 6.1 1145.2 148.2

1995 5.6 1143.0 152.4

1996 5.4 1106.9 156.9

1997 4.9 1070.2 160.5

1998 4.5 1080.6 163.0

1999 4.2 1102.3 166.6

2000 4.0 1103.6 172.2

2001 4.7 1140.3 177.0

2002 5.8 1196.3 179.9

2003 6.0 1273.5 184.0

2004 5.5 1344.2 188.9

2005 5.1 1371.5 195.3

2006 4.6 1374.2 201.6

2007 4.6 1372.1 207.3

2008 5.8 1432.8 215.2

2009 9.3 1634.8 214.5

2010 9.6 1740.9 218.1

2011 8.9 2006.2 224.9

2012 8.1 2309.1 229.6

 MONETARY AND FISCAL POLICY 129

10

8
Unemployment

3
6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0

M1 /P

Chart 12-1

THE LANGUAGE OF ECONOMICS 12

Stabilization
Usually when economists talk about “stabilizing” the economy, they mean that they want to
dampen output fluctuations⎯reduce the size of recessions and booms, so that the path of output
over time is smoother. In an AS-AD framework, this means using fiscal and monetary policy to
keep output as close as possible to potential, or full-employment, output.

REVIEW OF TECHNIQUE 12

Working with Multipliers

A multiplier gives you the amount that some endogenously determined variable increases in
response to a unit change in some other exogenously determined variable. It tells you how far a
particular curve shifts in response to a change in one of the variables that was held constant when
it was drawn.

Take the multiplier

G = 1
1 − c(1 − t )

from Chapter 10, for example: Chapter 10 tells us that a $1 increase in autonomous spending (𝐴̅)
( )
will increase output by ($1) x (  G ), or $ 1− c(11− t ) , when the level of investment is held constant.
130 CHAPTER 12

We can interpret this as a curve shift if we recall from Chapter 11 that investment can only
remain constant when the interest rate does not change. A $1 increase in autonomous demand,
therefore, will increase output by this amount, at each possible level of the interest rate. The IS
curve will shift outward by an amount  G .

Unless the economy is in a liquidity trap, the AD curve will not shift out this far. The multiplier
above does not consider the effect that increased demand will have on the interest rate, and
therefore on investment. There is another multiplier⎯one which takes the slopes of both the IS
and LM curves into account⎯that does this.

Even this fiscal policy multiplier (derives in Chapter 11, optional Section 5), however, does not
tell us how much the equilibrium level of output increases in response to a given change in
autonomous spending. It tells us only how far to shift the AD curve.

While multipliers do tell you how far, and in what direction, to shift various curves, they do not
say anything about how these shifts affect the equilibrium values of the models’ endogenous
variables. Be careful not to jump to conclusions.
 MONETARY AND FISCAL POLICY 131

CROSSWORD

ACROSS 1 2 3

2 these tell you how far to

shift curves
4 type of monetary policy,
prevents crowding out
7 expansionary policy; lowers 4 5

interest rates, increases AD

6
10 falls when expansionary
7
fiscal policy used
11 LM curve, classical case
8 9

DOWN 10

1 The central bank should ___

11
the money supply to
prevent expansionary fiscal
policy from raising the
interest rate
3 trap, people will hold as
much money as is supplied
5 accommodating a fiscal expansion 8 investment demand becomes less sensitive to
____ the budget deficit the interest rate; IS curve gets ____
6 MPC increases; IS curve gets ____ 9 interest rate used in IS-LM diagram

FILL-IN QUESTIONS

1. Monetary policy cannot affect output or the interest rate when the economy is in a
___________________.

2. Fiscal policy causes complete crowding out in the ___________________.

3. When money demand is relatively insensitive to the interest rate, the LM curve is
___________________.

4. When investment is very sensitive to the interest rate, the IS curve is _________________.
(Hint: when investment is sensitive to the interest rate, is the b large or small?)
132 CHAPTER 12

5. When expansionary fiscal policy raises the real interest rate and reduces investment, we say
there is ___________________.

6. The central bank can prevent a fiscal expansion from raising the real interest rate by
___________________ it.

7. The real interest rate the ____________________________ minus _______________________.

8. The policy mix that an economy chooses affects the _______________________ of output.

9. A fiscal expansion ___________________ investment.

10. The central bank can change the money supply by engaging in ________________________.

TRUE-FALSE QUESTIONS

T F 1. Monetary Policy is more effective when the LM curve is relatively steep.

T F 2. Fiscal Policy is more effective when the LM curve is relatively flat.

T F 3. Monetary policy is always more effective than fiscal policy.

T F 4. The effectiveness of monetary policy depends only on the slope of the LM curve.

T F 5. Monetary policy first affects AD, and only indirectly affects the interest rate.

T F 6. Expansionary monetary policy and fiscal policy affects investment differently.

T F 7. A combination of expansionary fiscal and expansionary monetary policy can be

used to prevent crowding out.

T F 8. An increase of equal size in transfers and in government spending will shift the
IS curve the same distance.

T F 9. An increase in the mpc will make the IS curve steeper.

T F 10. An increase in the mpc will make the IS curve flatter.

MULTIPLE-CHOICE QUESTIONS

1. Fiscal policy is most effective in

a. the Classical case c. France
b. a liquidity trap d. the long run
 MONETARY AND FISCAL POLICY 133

2. Monetary policy is most effective in

a. the Classical case c. Belgium
b. a liquidity trap d. the neoclassical growth model

3. Fiscal policy is more effective when

a. investment is relatively sensitive to c. investment is relatively insensitive to
the interest rate the interest rate
b. sensitivity doesn’t matter d. fiscal policy is never effective

4. Monetary policy is more effective when

a. the IS curve is steep c. slope of IS curve doesn’t matter
b. the IS curve is flat d. it’s never effective

5. Expansionary fiscal policy generally

a. encourages investment c. has no effect on investment
b. discourages investment d. lowers the interest rate

6. Expansionary monetary policy generally

a. encourages investment c. has no effect on investment
b. discourages investment d. raises the interest rate

7. A combination of loose (expansionary) fiscal policy and tight (contractionary) monetary policy
a. raises Y, lowers i c. raises Y, can’t predict effect on i
b. raises i, lowers Y d. raises i, can’t predict effect on Y

8. Contractionary monetary policy has been used in the past to combat

a. inflation c. unemployment
b. recession d. famine

9. The central bank is able to choose whether or not to ________________ a fiscal expansion.
a. illuminate c. accommodate
b. prevent d. run
10. The multiplier aG = 1
1 - c(1 - t)
tells us how far the _____ curve shifts in response to an
increase in autonomous spending.
a. IS c. AS
b. LM d. AD
134 CHAPTER 12

CONCEPTUAL PROBLEMS

1. Will proportional income taxes make monetary policy more effective, less effective, or will
their presence have no effect?

2. Will proportional income taxes increase, decrease, or not affect the expansionary effect of an
increase in government spending (the amount it raises output) in the short run?

3. Why can’t the interest rate go below the zero lower bound?

TECHNICAL PROBLEMS

1. How far, and in what direction, will the IS curve shift in response to a $100 increase in
government spending?

2. How far, and in what direction, will the AD curve shift in response to a $100 increase in
government spending? If the LM curve is upward-sloping, should this AD shift be bigger or
smaller than the IS shift in problem 1?

3. How far, and in what direction, will the LM curve shift if the money supply (M) increases
$100. (Assume that the price level is constant.)
Hint: Use the equation for the LM curve: M / P = kY - hi . If you hold i constant and find how much Y
changes, this will tell you how far (horizontally) the LM curve shifts.

4. How far, and in what direction, will the AD curve shift in response to this $100 increase in the
money supply? Should this AD shift be bigger or smaller than the LM shift in Problem 3?

5. Under what conditions will the level of output increase by exactly the same amount as
aggregate demand?

6. Under what conditions will the level of output not be affected by changes in aggregate
demand (AD shifts)?

7. Suppose that government spending were not simply exogenous. If it increased and decreased
with the output gap (the difference between potential output (YP) and actual output (Y))
according to the rule
G = G + d(YP - Y ),

where d > 0, what would happen to the slope of the IS curve? Would this make monetary
policy more effective or less effective?