JentooMacroeconomics

AP® Macroeconomics · Unit 5 · Topic 5.1

Fiscal and Monetary Policy Together

Fiscal and monetary policy both move the interest rate, so their combined effect on output depends on whether they push that rate the same way or opposite ways, never a simple sum.

Watch it drawn4 questionsPractice

Fiscal policy and monetary policy don't act on the economy in isolation. They both pass through the same lever: the interest rate. Expansionary fiscal policy means the government spends more or taxes less, and usually borrows to cover the gap. That extra borrowing increases the demand for loanable funds, pushing the interest rate up. Expansionary monetary policy means the central bank increases the money supply, which pushes the interest rate down. If a government runs expansionary fiscal policy while the central bank runs contractionary monetary policy, both forces push the interest rate up at once, reinforcing each other. Higher rates make borrowing expensive, so private investment gets crowded out, partly undoing the fiscal boost to output.

When both policies expand together, the story flips. Fiscal expansion pushes rates up through more borrowing, but monetary expansion pushes rates down through a bigger money supply. These two effects pull the interest rate in opposite directions, so the net change in the rate depends on which force is stronger. Output rises from both the fiscal stimulus and the monetary stimulus, but the interest rate's path is no longer predictable without knowing the relative size of each policy.

This is why combining two expansionary policies never simply doubles the result. The interest rate is the channel connecting the money market, the loanable funds market, and aggregate demand. A shift in either market changes borrowing costs, which shifts investment spending, which shifts the AD curve and therefore real GDP and the price level. Tracking all three graphs together, money market, loanable funds, and AD-AS, is how you see the full story: policies that move rates the same direction reinforce each other, and policies that move rates opposite directions partly cancel through investment.

Key terms

Crowding out
The reduction in private investment caused by higher interest rates, often from increased government borrowing.
Loanable funds market
The market where savers supply funds and borrowers demand them, setting the real interest rate.
Expansionary fiscal policy
Increased government spending or lower taxes meant to raise aggregate demand and output.
Contractionary monetary policy
A central bank action that shrinks the money supply to raise interest rates and slow the economy.

Watch it explained

  1. How it worksWalk me through expansionary fiscal policy and contractionary monetary policy fighting over the interest rate.
  2. Going furtherWhat happens to output and interest rates when both policies expand at the same time?
  3. Common mistakeWhy doesn't a government and a central bank pulling together simply double the effect?
  4. Ties togetherHow do the money market, loanable funds, and AD-AS graphs move together in one policy story?

Check yourself

Your turn1 of 2
A government uses expansionary fiscal policy while the central bank simultaneously uses expansionary monetary policy, both aimed at the same recession. A student assumes the combined boost to GDP must simply be double what either policy would produce alone. What's the flaw in that assumption?

End of topic.

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