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 ISShift of LMMovement in OutputMovement in Interest Rate
Increase in taxesLeftNoneDownDown
Decrease in taxesRightNoneUpUp
Increase in spendingRightNoneUpUp
Decrease in spendingLeftNoneDownDown
Increase in moneyNoneDownUpDown
Decrease in moneyNoneUpDownUp

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