Monetary and Fiscal Policy

Md. Kaesuzzaman
 Monetary Policy
The regulation of the money supply and interest
rates by a central bank in order to stabilize
economy.
Monetary policy works through the money market
to affect output and employment.
In an open market operation the central bank buys
bonds in exchange for money thus increasing the
stock of money, or it sells bonds in exchange for
money paid by the purchasers of the bonds, thus
reducing the money stock.
 Fiscal Policy
Fiscal policy is the means by which a
government adjusts its levels of spending in
order to monitor and influence a nation’s
economy.

It works through the goods market.

 Income

Goods Market
Assets Markets

Money Market Bond Market

Aggregate Demand
Demand Demand Output
Supply Supply

Interest Rates

Monetary Policy Fiscal Policy

Figure: The Structure of IS-LM Model

 The Goods Market and the IS curve
The IS curve shows combinations of interest
rates and levels of output such that the goods
market is in equilibrium.
Interest Rate

i1 E1

i2 E2

IS

Y1 Y2
Income, Output

Figure: The IS Curve

The IS curve is negatively sloped because a
higher level of the interest rate reduces
investment spending, thereby reducing
aggregate demand and thus the equilibrium
level of income.
 The Money Market and the LM Curve

The LM curve shows combinations of interest

rates and levels of output such that the money
market is in equilibrium.
 LM
E2
Interest Rate

i2
E1
i1

Y1 Y2
Income, Output

Figure: The LM Curve

The LM curve is positively sloped. An increase in
the interest rate reduces the demand for real
balances. To maintain the demand for real
balances equal to the fixed supply, the level of
income has to rise. Money Market equilibrium
implies that an increase in the interest rate is
accompanied by an increase in the level of
income.
 Equilibrium in the Goods and Money Markets

For simultaneous equilibrium, interest rates and

income levels have to be such that both the
goods market and the money market are in
equilibrium.
IS-LM are the two main macroeconomic policy
tools the government can call on to try to keep
the economy growing at a reasonable rate.
Fiscal policy has its initial impact in the goods
market, and monetary policy has its initial
impact mainly in the assets markets. But
because the goods and assets markets are
closely interconnected, both monetary and
fiscal policies have effects on both the level of
output and interest rates.
 LM
LM1
E
Interest Rate

i0
E1
i1

IS
Y0 Y1
Income, Output

Figure: Monetary Policy

 An Increase in Government Spending

LM
E1
i1
Interest Rate

E E2
i0

IS1
IS
Y0 Y1 Y2
Income, Output

Figure: Effects of an Increase in Government Spending

 Monetary Accommodation of Fiscal Expansion

Monetary policy is accommodating when, in the

course of a fiscal expansion, the money supply is
increased in order to prevent interest rates from
increasing. That means the central Bank prints
money to buy the bonds with which the
government pays for its deficit.
 LM

E2 LM1
i2
Interest Rate

E E1
i0

IS1
IS
Y0 Y2 Y1
Income, Output

Figure: Monetary Accommodation of Fiscal Expansion

The Composition of Output and the Policy Mix

The question of the Monetary-Fiscal policy mix arises

because expansionary monetary policy reduces the
interest rate while expansionary fiscal policy increases
the interest rate.

Government have to choose the mix in accordance

with their objectives for economic growth.
 The Composition of Output and the Policy Mix

E1 LM
Interest Rate

E
i0

E2

IS
Y0 Y’
Income, Output

Figure: Expansionary Policies and the Composition of Output