- Mechanics of Monetary and Fiscal Policy
- What is Money?
- How is Money Created?
- Official Measures of Money: M1 and M2
- Demand and Supply of Money
- Fisher Effect
- What do Central Banks do?
- Tools for Implementing Monetary Policy
- Features of Effective Central Banks
- The Monetary Policy Transmission Mechanism
- Expansionary vs. Contractionary Monetary Policy
- Limitations of Monetary Policy
- Role of Fiscal Policy
- Tools of Fiscal Policy
- Fiscal Multiplier and Balanced Budget Multiplier
- Ricardian Equivalence
- Challenges in Implementing Fiscal Policy
- Expansionary Vs. Contractionary Fiscal Policy
- Combined Effects of Monetary and Fiscal Policy
Combined Effects of Monetary and Fiscal Policy
Fiscal policy is implemented by the government and the monetary policy is decided by the central bank of the country. Both the policies can be expansionary or contractionary. In this article, we will take a look at the combined effects of monetary and fiscal policy on the economy in different scenarios:
Expansionary Fiscal Policy plus Expansionary Monetary Policy
- Economy will highly expand.
- Interest rates will be low.
Contractionary Fiscal Policy plus Contractionary Monetary Policy
- Economy will contract.
- Interest rates will be high.
Expansionary Fiscal Policy plus Contractionary Monetary Policy
This happens during a negative supply shock, i.e., a sudden decrease in supply. The government will follow expansionary policy to increase output, and monetary authorities will follow contractionary policy to reduce inflation, that was induced by shortage of output.
- Aggregate demand will be higher (fiscal policy)
- Interest rate will be higher (monetary policy)
Contractionary Fiscal Policy plus Expansionary Monetary Policy
- Interest rates will fall
- Consumption and output will increase
The following table summarizes the effects of Monetary and Fiscal policy.
|Shift of IS||Shift of LM||Movement in Output||Movement in Interest Rate|
|Increase in taxes||Left||None||Down||Down|
|Decrease in taxes||Right||None||Up||Up|
|Increase in spending||Right||None||Up||Up|
|Decrease in spending||Left||None||Down||Down|
|Increase in money||None||Down||Up||Down|
|Decrease in money||None||Up||Down||Up|