Download Comparing fiscal policy and monetary policy in the IS

Comparing fiscal policy and monetary policy in the IS-LM model
Screen 1
In this presentation we compare the impact of fiscal policy with that of monetary policy
in the IS-LM model. Before you start this section make sure you are thoroughly familiar
with the following:
Expansionary and contractionary fiscal policy
Expansionary and contractionary monetary policy
Fiscal policy in the IS-LM model
Monetary policy in the IS-LM model
Screen 2
Let’s start by comparing the impact of an expansionary fiscal policy with that of an
expansionary monetary policy.
An expansionary fiscal policy implies an increase in government spending and/or a
decrease in taxation. An expansionary monetary policy implies an increase in the nominal
money supply.
Both these policies increase the demand for goods, which eventually leads to an increase
in the level of output.
What is different is how the different variables as reflected by the IS-LM model are
influenced.
For instance, in the case of an expansionary fiscal policy that entails an increase in
government spending, the initial effect is on the goods market where the demand for
goods increases and eventually leads to an increase the level of output. The increase in
output and income also causes an increase in investment spending since the level of sales
increases due to higher output.
The resultant higher output spills over into the financial market where the demand for
money increases and causes an increase in the interest rate which brings down investment
spending on the goods market and the change in investment is indeterminate.
The increased money supply under an expansionary monetary policy first impacts the
financial market where the interest rate declines. The decline in the interest rate then
spills over into the goods market where investment increases and causes an increase in
the demand for goods and the level of output.
Screen 3
The IS-LM model shows that an expansionary fiscal policy is charaterised by a rightward
or upward shift of the IS curve to a new equilibrium level of income and output where the
goods and financial markets are in equilibrium at point c.
In the case of an expansionary monetary policy the LM curve shifts to the right or
downward to a new equilibrium level of income and output where the goods and financial
markets are in equilibrium at point b.
The end result of an expansionary fiscal policy in comparison with that of an
expansionary monetary policy is as follows:
In both cases the demand for goods and the level of output are higher. For an
expansionary fiscal policy the interest rate is higher while for monetary policy the interest
rate is lower. While for an expansionary monetary policy the investment spending is
definitely higher it is uncertain whether it is higher for an expansionary fiscal policy since
it first decreases and then increases .
Screen 4
At this point we should compare the effect of a contractionary fiscal policy with that of a
contractionary monetary policy.
A contractionary fiscal policy implies a decrease in government spending and/or an
increase in taxation. A contractionary monetary policy implies a decrease in the nominal
money supply.
Both these policies decrease the demand for goods , which eventually leads to a decrease
in the level of output.
What is different is how the different variables reflected by the IS-LM model are
influenced.
For instance, in the case of a contractionary fiscal policy that entails a decrease in
government spending , the initial effect is on the goods market where the demand for
goods decreases, which eventually leads to a decrease in the level of output. Lower
output and income also causes a decrease in investment spending because lower demand
reduces sales.
Lower output then spills over into the financial market where the demand for money
decreases and the interest rate declines. The decrease in the interest rate then increases
investment spending on the goods market and the change in investment is indeterminate.
The reduced money supply under a contractionary monetary policy first impacts the
financial market by causing a higher interest rate . The increase in the interest rate then
spills over into the goods market where investment decreases which dampens the demand
for goods and the level of output .
Screen 5
The IS-LM model shows that a contractionary fiscal policy is characterised by a leftward
or downward shift of the IS curve to a new equilibrium level of income and output where
the goods and financial markets are in equilibrium at point c.
In the case of a contractionary monetary policy the LM curve shifts to the left or upwards
to a new equilibrium level of income and output where the goods and financial markets
are in equilibrium at point b.
The end result of a contractionary fiscal policy compared to that of a contractionary
monetary policy is as follows:
In both cases the demand for goods and the level of output are lower. For a
contractionary fiscal policy the interest rate is lower while for a contractionary monetary
policy the interest rate is higher. While for a contractionary monetary policy the
investment spending is definitely lower it is uncertain whether it is lower for a
contractionary fiscal policy since it first decreases and then increases.