5.1 Fiscal and Monetary Policy Actions in the Short Run
Fiscal and monetary policy both shift AD, but combined actions can reinforce or offset each other's effects on output, prices, and interest rates.
Both policies work through aggregate demand in the short run: expansionary fiscal policy (more spending or lower taxes) and expansionary monetary policy (lower interest rates) each shift AD right, raising real output and the price level. Contractionary versions shift AD left.
The difference shows up in interest rates. Fiscal expansion is financed by borrowing, which raises the real interest rate in the loanable funds market; monetary expansion lowers interest rates directly. So if both are expansionary at once, output clearly rises but the net effect on interest rates is INDETERMINATE — a favorite FRQ point.
Policy combinations can also offset: expansionary fiscal policy paired with contractionary monetary policy leaves output ambiguous while clearly pushing interest rates up. Work each policy's AD and interest-rate effect separately, then compare directions before answering.
Key terms for 5.1
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Practice the math
Assuming combined expansionary fiscal and monetary policy must raise interest rates. Fiscal expansion pushes rates up, monetary expansion pushes them down — the interest-rate effect is indeterminate, while output unambiguously rises.
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