147. Interaction between monetary & fiscal policy

Fiscal policy and monetary policy are the two tools used by the State to achieve its macroeconomic objectives. While for many countries the main objective of fiscal policy is to increase the aggregate output of the economy, the main objective of the monetary policies is to control the interest and inflation rates. The IS/LM model is one of the models used to depict the effect of policy interactions on aggregate output and interest rates. The fiscal policies have a direct impact on the goods market and the monetary policies have an direct impact on the asset markets; since the two markets are connected to each other via the two macrovariables output and interest rates, the policies interact while influencing output and interest rates.

Traditionally, both the policy instruments were under the control of the national governments. Thus traditional analyses were made with respect to the two policy instruments to obtain the optimum policy mix of the two to achieve macroeconomic goals, lest the two policy tools be aimed at mutually inconsistent targets. But more recently, owing to the transfer of control with respect to monetary policy formulation to central banks, formation of monetary unions (like European Monetary Union formed via the Stability and Growth Pact), and attempts being made to form fiscal unions, there has been a significant structural change in the way in which fiscal and monetary policies interact.

There is a dilemma as to whether these two policies are complementary, or act as substitutes to each other for achieving macroeconomic goals. Policy makers are viewed as interacting as strategic substitutes when one policy maker's expansionary (contractionary) policies are countered by another policy maker's contractionary (expansionary) policies. For example: if the fiscal authority raises taxes or cuts spending, then the monetary authority reacts to it by lowering the policy rates and vice versa. If they behave as strategic complements, then an expansionary (contractionary) policy of one authority is met by expansionary (contractionary) policies of the other.

The issue of interaction and the policies being complements or substitutes for each other arises only when the authorities are independent of each other. But when, the goals of one authority are made subservient to those of the other, then one authority solely dominates the policy making and no interaction worthy of analysis would arise. Also, it is worthwhile to note that fiscal and monetary policies interact only to the extent of influencing the final objective. So long as the objectives of one policy are not influenced by the other, there is no direct interaction between them.

148. Monetary policy and the ad curve

Aggregate Demand

* Many factors influence aggregate demand besides monetary and fiscal policy.

* In particular, desired spending by households and business firms determines the overall demand for goods and services.

* When desired spending changes, AD shifts.

* Monetary and Fiscal policy are used to offset those shifts in AD.

Aggregate demand (AD) is the total demand for final goods and services in the economy at a given time and price level. It specifies the amounts of goods and services that will be purchased at all possible price levels. This is the demand for the gross domestic product of a country. It is also referred to as the effective demand.

The aggregate demand curve illustrates the relationship between two factors - the quantity of output that is demanded and the aggregated price level. Another way of defining aggregate demand is as the sum of consumer spending, government spending, investment, and net exports. The aggregate demand curve assumes that money supply is fixed. Altering the money supply impacts where the aggregate demand curve is plotted.

Contractionary Monetary Policy

Contractionary monetary policy decreases the money supply in an economy . The decrease in the money supply is mirrored by an equal decrease in the nominal output, otherwise known as Gross Domestic Product (GDP). In addition, the decrease in the money supply will lead to a decrease in consumer spending. This decrease will shift the aggregate demand curve to the right.

This graph shows the effect of contractionary monetary policy, which shifts aggregate demand (AD) to the right.

Expansionary Monetary Policy

Expansionary monetary policy increases the money supply in an economy. The increase in the money supply is mirrored by an equal increase in nominal output, or Gross Domestic Product (GDP). In addition, the increase in the money supply will lead to an increase in consumer spending. This increase will shift the aggregate demand curve to the left.

In addition, the increase in money supply would lead to movement up along the aggregate supply curve. This would lead to a higher prices.

How Monetary Policy Influences Aggregate Demand

For the U.S. economy, the most important reason for the downward slope of the aggregate-demand curve is the interest-rate еffect.