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Monetary Policy And Fiscal Policy

Using the IS/LM model, contrast monetary policy with fiscal policy. Why has monetary policy been favoured over “activist fiscal policy” in recent decades and why has there been a recent resurgence of Keynesian “activist fiscal policy”? Draw on actual examples/case studies as appropriate, as well as the relevant literature.

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The IS/LM model is a versatile tool that allows us to understand economic phenomena that cannot be analyzed using simple Keynesian cross framework. It helps us understand how monetary policy affects economic activity and interacts with fiscal policy to produce a certain level of aggregate output. It also helps us understand how the levels of interest rates are affected by the change in investments, as well as by changes in monetary policy and fiscal policy. How monetary policy is best conducted and how the IS/LM model generates the aggregate demand curve for aggregate demand and supply analysis.

Constructing the IS/LM Model

The IS/LM model, a macroeconomic framework, demonstrates the relationship between interest rates and real output in the money market and goods & services market. When constructed, it helps generate an equilibrium in which the aggregate output produced equals the aggregate demand (assuming a fixed price level in real and nominal quantities). The IS curve represents the relationship between aggregate output and the interest rate. The LM curve represents the relationship between the quantity of money demanded and the money supplied. The resulting intersection determines the equilibrium level of aggregate output as well as the interest rate.

Before analyzing the IS/LM model it is necessary to understand the factors that causes a shift in the IS and LM curve. Factors that cause the IS curve to shift are changes in the autonomous consumption for e.g. increase in the confidence about the economy, changes in the wealth etc., changes in the investment spending (unrelated to the interest rates) e.g. changes in technology, increase in business confidence, etc., changes in government spending, changes in taxes and changes in net exports (unrelated to interest rates e.g. trade policies, changes in tastes, etc. Additionally changes in the interest rate or aggregate output will only cause a movement along the IS curve.

Changes in interest rate or aggregate output are movements along the LM curve. The factors that causes the shift in the LM curve are Money demand (Md) and money supply (Ms). When the money supply decreases, the LM curve shifts left for a given income, Y1. This is because when the supply falls MsChanges in the money demand (unrelated to interest rate or income) if decreased, the LM curve shifts right for a given income, Y1. This is because Ms>Md. People buy bonds; and prices for bonds increase as the interest rate falls. As output does not change, the LM shifts to the right as the interest rates fall to satisfy the money market equilibrium.

The IS/LM Model & The Monetary and Fiscal Policy

In lieu to these factors we can hypothesize how fiscal and monetary policy affect the IS/LM model. Both policies shift the curve as shown below:

The effectiveness of the Fiscal or Monetary policy depends on the slope of the IS and the LM curves. According to the classical Keynesian view where demand for money does not respond to interest rate and only reflects incomes. The LM curve is vertical (demand for money is interest inelastic). In this case Fiscal policy is ineffective because of crowding out. This is because irrespective of the increase in government spending and the IS curve shifting out the aggregate output remains same and only interest rate increases. On the contrary a Monetary policy is more effective because an increase is money supply leads to an increase in output and a decrease in interest rates (LM moves to LM’).

In an event Liquidity trap where interest rates are low and expectations are that is rises, the LM curve might be close to horizontal. In this case money supply does not shift the LM curve and interest rates do not change deeming Monetary policy ineffective. In this case Fiscal policy is more effective as IS curve can shift outwards leading to an increase in goods produces (depleting inventories) and the output increases (IS moves to IS’).

When investments are insensitive to interest rate the IS curve is horizontal. In this case again Monetary policy is ineffective as interest rates fall but the aggregate output remains same (LM moves to LM’). However fiscal policy increases not only output but also interest rates (IS moves to IS’).

IS/LM In the Long-Run

Freidman (1968) said that money in the long run is neutral, but monetary policy can be a powerful tool in the short-run because money in the short run is not neutral. Thus with respect to the IS/LM model, assuming prices are fixed, when money supply increases as reflected in panel (a) the LM curves shifts outwards, however because of the shift the new aggregate output far exceeds the natural rate of output, Prices rise decreasing M/P and thus eventually the LM curve shifts back. Similarly in the case of a fiscal policy, as reflected in panel (b), an increased government spending, the IS shifts outwards, once again as the new aggregate output is greater than the natural rate of output. Price rise decreases M/P, shifting the LM curve inwards (LM1 to LM2) to natural output Yn and increased interest rates. (i1 = i2′).

Panel A (left) Panel B (right)

What can be noticed from panel (b) is that government spending in the long-run has raised the interest levels and causes the problem of crowding out, causing investments and net exports to fall enough to offset the government spending. We can conclude that from the IS/LM model:

Movements of nominal interest rates and, to a lesser extent, real rates are more accountable by monetary actions rather than fiscal actions.

Short-run effect of monetary and fiscal policies does increase in outputs but neither affects output in the long-run.

Investment ratios and net export ratios are temporarily affected by monetary actions, but fiscal policies actions appear to be more permanent.

Decade of Monetary Policy

Fiscal policy lost favour amongst policymakers due to the inside lags which are long, sometimes longer than the recession, change in taxes are usually deployed on a temporary basis that ends up weakening the measure and availability of monetary policy that has superior stabilization mechanism. Expansionary fiscal policy leads to Neo classical synthesis like crowding out, Neo classical Macroeconomics like rational expectations, Ricardian equivalence.

Stagflation resulting from fiscal policy creates a distortion called ‘inflation bias’. (Kydeland and Prescott, 1977), (Barro and Gordon, 1983) who analyzed the inflation bias found that in the presence of a short run Phillips curve, discretionary fiscal policy leads to a inefficiently high rate of inflation on average due to high inflation expectation which led to widespread adoption of Monetary policy.

Monetary policy is the process a country or monetary authority uses to control the supply of money, availability of money and cost of money or interest rate to attain a set of objectives like growth and stability. The objective of the monetary policy is price stability or restraining inflation or stopping general increases in the prices of goods and services. Inflation targeting, exchange rate peg and money supply growth are some of the monetary policy framework used in practice by countries or monetary authorities.

Let us investigate alternative methods available to monetary regimes that have been used in the past like pegging the exchange rate, targeting money, targeting nominal GDP and pre-emptive monetary policy without explicit targets and inflation targeting.

Pegging the exchange rate policy is to fix the exchange rate of the currency to that of a low inflation country who is usually a major trading partner. By maintaining the exchange rate at a fixed value the domestic inflation should eventually align with the pegged country. If the relative prices of goods produced in domestic and foreign countries are too large it becomes more difficult to maintain the peg. Exchange rate peg constrains the short run opportunism by central bank and it is very clear and simple leading to decrease in inflationary bias. Although maintenance of peg constrains the monetary authorities to use monetary policy for any other purpose such as short run domestic stabilization especially when the domestic business cycle is out of sync with that of the pegged country. A successful peg also tends to depress domestic economic activity by making its exports less competitive. Peg is also a target of highly speculative attack. Exchange rate peg does not solve the problem of maintaining price stability but it shifts the problem of maintaining price stability to another country or monetary authority. For a well functioning system there must be a system wide nominal anchor as a whole, exchange rate as a nominal anchor is not an option for the system as a whole.

Targeting money is targeting a monetary aggregate like narrow measure of money M1 and broader measures like M2 and M3. Targeting money is based on (Milton Friedman’s, 1969) recommendation that central banks should maintain a constant rate of monetary growth. In practice no central bank has followed a rigid rule for money growth in order to meet other short term objectives like stabilization of output or exchange rate. Targeting money gives central banks freedom to adjust monetary policy to domestic conditions. Monetary aggregates are easy to measure without too long a lag and central banks can easily control the rate of money growth. Targeting money is only useful if there is a reliable relationship between money growth and economy (goal variables like GDP or inflation). In many countries the relationship between money and the economy has proven to be highly unstable making it less effective tool as a monetary policy.

Targeting nominal GDP measures output as well as price stability and is close in spirit to inflation targeting although having a nominal GDP target forces government to make real GDP growth estimate which is not precise public. It is politically problematic because in case of excessively pessimistic estimate, government is accused of preventing economy from reaching its maximum potential and high estimate can lead to excessively inflationary policies making inflation targeting better than nominal GDP targeting. The data on prices is timelier and more frequently reported than nominal GDP making inflation targeting better than nominal GDP targeting. Inflation targeting provides considerable flexibility for policy in the short run as compared to nominal GDP targeting and finally the concept of inflation in consumer prices is better understood than nominal GDP.

Pre-emptive monetary policy without using an explicit anchor has been extremely successful in USA where no explicit framework or a coherent strategy is articulated. The strategy carefully monitors future inflation and uses pre-emptive monetary policy against threat of inflation. This gives the central bank discretion to deal with unforeseen events in the economy. Although it is not stated as inflation targeting it is under the wrap inflation targeting, formal adoption to inflation targeting would enhance transparency and would guarantee future adherence to the policy.

Monetary policy transmission mechanism of inflation targeting has become increasingly popular during the last 20 years as it helped some countries to keep inflation at desirable low and stable levels while maintaining solid growth rates. (Mishkin and Schmidt-Hebbel, 2001- 2006), (Walsh, 2008) and (Ball & Sheridan, 2005) argue that almost all countries who used inflation targeting managed to lower inflation rate as demonstrated in Appendix A and the common view is that inflation targeting doesn’t worsen economic growth. There is also evidence that not many inflation target countries (apart from Spain and Finland) abandon inflation targeting suggesting that inflation targeting is a successful monetary policy leading to more countries and monetary authorities adopting inflation targeting.

Resurgence OF Keynesians “activist fiscal policy”

Since 1930’s Chicago viewed fiscal policy activism only justified during abnormal circumstance. They viewed monetary policy as a useful tool to control inflation but ineffective in times of recessions, although they proposed discretionary fiscal policy and compensatory public finance offset contracting effects of recessions. Simons (1983) advocated that once a deflation has gotten underway, there is a no limit to the decline in employment and prices if the central government fails to use fiscal stimulus. Douglas and Aaron (1931) voiced monetary theory is limited “the difficulty come from the demand side as to whether business, exposed to such difficulties, would wish to borrow more” even during an expansionary monetary policy with reduced interest rates.

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Blinder (2006) noted that discretionary fiscal policy does more harm than good except in periods of ‘abnormal’ economic activity (i.e. recession). Withstanding this argument, mainstream economists recognize ‘abnormal’ circumstances where traditional monetary policy tools become ineffective to stabilize business cycle. This can be noted from the Japanese recession of 1990’s when interest rates reached zero bound, crowding effects were unimportant and the duration of the economic recession proved longer than the fiscal policy lags.

In these abnormal times fiscal policy can play the principal role in stabilizing the business cycle by supplementing the aggregate demand through deficit government spending or tax cuts financed by money supply.

In August 2007 world economies witnessed the global financial crisis, which was triggered by a liquidity shortfall in the United States banking system. The collapse was related to the global housing bubble, which caused securities tied to real estate pricing to plummet. Investor consumer confidence was shaken and economies worldwide slowed down as credit tightening and international trade declined. Additionally in the first half of 2008 there was further pressure in economies caused by the rise in oil and commodity prices that squeezed on margins against the background of the slowing demand, which added to restrictions in working capital for companies. Thus cost cutting mechanism were placed by companies and resulted in sharp rise in unemployment’s. All of this resulted in sharp declines in aggregate demand and unemployment reinforced by illiquidity and investment confidence deeming monetary policy weak.

To combat this global recession, Paul Krugman, Joseph Stiglitz,Martin Feldstein, Stanley Fischer suggested expansionary fiscal policy. Auerbach & Gale (2009) stated that “… focus on automatic stabilizers and the use of monetary policy seems now to have come to an abrupt halt”. Since the start of the August 2007 financial crisis, many central banks throughout the developed and developing world have reduced their interest rates turning negative in real terms in many instances. Caldentey and Vernengo (2010) noted that credit market dysfunction and illiquidity has limited monetary policy as a stabilizing tool, thus governments have had to strongly intervene in financial markets, not only providing bailouts but also direct liquidity to borrowers and investors in important credit markets, and purchase liabilities or assets of important financial institutions.

Like many economies China also faced uncomfortable combinations of slowing growth and rising unemployment, driven by, first, the energy consumption trends, considered a harbinger of industry activity had not rebounded. Second, import demands from United States had remained weak, and Third, imports for intermediary product processing dropped in 2008-Q4 showing its incapability’s to re-export processed electronics and related products. Appendix 3 shows the reflects the falling GDP and production rates, exports, stock market and real estate prices, highlighting the depth of its recessions.

To combat the recession China’s government structured expansionary fiscal and monetary policy. It structured a fiscal stimulus of $588 billion (¬15% of Chin’s GDP), aimed to target infrastructure as mentioned in Appendix 4, raised export tax rebates and temporarily eliminated export taxes; providing temporary financial support to certain high-tech and agricultural industries, & decreases property taxes for new homeowners and simplified housing certification.

Additionally in September 2008 China declared expansionary monetary policy by lowering the interest rates from 218 basis points to 100 in November, thus shifting the LM curve to the right, and stimulating aggregate demand. However these rates mostly benefited state-owned enterprises for smart lending as monetary policy is still tight, because China increased its reserve ratio in order to avoid higher inflationary expectations.

With an aggressive fiscal strategy, Chinese economy showed sign of recovery by early February 2009 and by April 2010 achieved an accelerated growth rate of 11.9%. These results reinforced the confidence in the IMF and OECD credit stimulus recommendations as Keynesian economists Paul Krugman announced the world had been saved from the threat of the second great depression thanks to the “Big Government”.


The argument over Fiscal and Monetary Policy has been subjected too much debate since the great depression in the 1930’s. Mainstream economics still consider fiscal policy as a sensible strategy; but it is “neither desirable nor politically feasible” as quoted by Eichenbaum (1997). It has historical examples for its failures but at abnormal times it is a sensible policy “by default” and “a courageous fiscal policy” is called to pump prime recovery.

However the mighty fiscal policy is subjected to further criticism as Caldentey & Verengo (2010) argue that in practice the fiscal stimulus packages are small, including the size of the multiplier thus they have “weak effects on output and employment in the majority of cases”, and that there could be dangers to fiscal solvency and macroeconomic stability instead.

None the less, historically business cycles are noted to have cyclic properties and economies are believed to have self-adjusting nature, as a recent statement of the Council of Economic Advisors of the President of the United States (2002) stated, “a key fact that recessions are followed by rebounds. Instead if periods of lower-than-normal growth were not followed by periods of higher-than-normal growth, the unemployment rate would never return normal.”


Appendix 1: Business Cycle

In all industries there are significant swings in the economic activity. In some years, most industries are booming with reduces unemployment and in others industries are operating below capacity and unemployment is high. These combinations of economic decline and expansions are referred as business cycles.

Burns & Mitchell’s (1946) key insights over business cycles was that many economic indicators move together. During expansion, not only does output rise but also employment and if the expansion is brisk then it also rises inflation. Conversely the opposite happens during a recession where outputs, employment and inflation contracts. Thus business cycles can be dated according to the direction of economic activity. The peak of the cycle refers to the last month before several key indicators being to fall and the trough can be referred to the last month where the indicators begin to rise.

Timing and duration of business cycles are irregular as shown Table 1. Between 1973 and 1982, we notice three peeks in the business cycles that also represent the three recessions in the United States economy.

Business cycles can occur due to the disturbances to the economy such as inflationary booms from surges in private and public spending or expectations of economic performance. Another possible cause can be both monetary and fiscal policies that can cause surges to aggregate demand and supply thus causing business cycles.

The Aggregate Demand curve can be derived from the Keynesian Cross framework. However it can also be derived from the IS/LM model by allowing price levels to vary.

As price levels increase from P1 to P3 the real money supply falls causing the LM curve to shift left. As the real money falls, output falls (The AD curve shows the relationship between output demanded and the price level). Thus with this information we can plot the AD curve (downward sloping).

Quantity theory approach suggests that monetary policy (money supply) is the only important source to shift in the aggregate demand curve, but components theory suggest fiscal policy, net exports and “animal spirits” are of equal importance. The aggregate demand curve shifts with shocks factors, money supply, government spending, taxes, net exports, consumer optimism and business optimism.

In the short run wages and prices take time to adjust to the economic conditions. This infers that the Aggregate supply curve in the short run is upward sloping. As business focus towards profit maximization, the quantity of output supplied is determined by the profits produces from each unit. If profits raise, more aggregate output is produced and vice versa.

Shifts in the curve are factored by changes in the cost of production. These are; tightness of the labor market, inflation expectation, attempts of wage push, and other factors of cost of production (energy).

Thus we formulate the equilibrium in the short run.

The equilibrium (E) is the level or aggregate output and price level where demand equals quantity supplied. If price greater the aggregate supply is greater than the demand and thus prices falls to equilibrium and vice versa.

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