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Course: Macroeconomics > Unit 5
Lesson 1: Fiscal and Monetary Policy Actions in the Short RunFiscal and monetary policy in parallel
In previous lessons we've learned how expansionary monetary policy and expansionary fiscal policy can be used to mitigate a recession, but they don't have to be used in isolation from each other. Often there is simultaneous use of fiscal and monetary policy. Learn what happens when they are used at the same time in this video.
Want to join the conversation?
- What does quasi-independent mean?
Help!(2 votes)- Quasi-independent means that in some sense the central bank is independent from the government and in other ways it is not. The idea is that even though the central bank is technically part of the government, it should be isolated from politics.(7 votes)
- Hi, couldn't contractionary fiscal policy lower supply, thereby increasing inflation even if the output gap is cured?(2 votes)
- Shouldn't government and the central bank work together at least a bit? If there is a negative output gap and both the bank and the government use multipliers to determine how much they should inject into the economy, wouldn't they be doing too much?(1 vote)
- Can someone explain this:
Expansionary monetary policies. Increasing government spending or decreasing taxes will cause the price level to increase. As a result of rising inflation expectations, the nominal interest rate will increase. The central bank engages in expansionary monetary policy, and the nominal interest rate will decrease.
Would this not just cause the interest rates to increase more?(1 vote)
Video transcript
- [Narrator] In previous
videos we've talked at length about fiscal policy and in other videos we've talked at length
about monetary policy. But now we're going to
talk about them together because at any given time in a country there is some type of
fiscal policy going on and in parallel there might be some type of monetary policy going on. But first let's just remind
ourselves what fiscal policy is. This would be government
changing the amount of taxes or government spending. So this is all about taxes and or and or, government, government spending. And why would that matter? Well if you change the amount of taxes you would change the amount
of money that individuals and or corporations might have which might change aggregate demand. Similarly, if the
government goes out there, spends more or less, that also
would change aggregate demand and this could be used as
a tool in order to attempt to engineer what the economy's output is. Now monetary policy on the other hand, it's very important not
to, not to get confused between these two. This is all about central, central banks. And I know a lot of you might be thinking, hey isn't the central bank
part of the government? And I would tell you, well it depends what country you're in and depends how you view part of the government. In the United States for example, the Federal Reserve System
is quasi-independent. It is true that the
executive makes appointments including the chairman of
the Federal Reserve Bank, but it should be acting independently from the federal government. Now this is all about central
banks changing money supply, so money supply, to impact or to target
oftentimes, interest rates. And now why would this matter
if we're thinking about engineering, so to speak,
where we are relative to full employment output? Well with low interest
rates, borrowing is cheaper so people might be willing
to borrow and spend more or corporations might be willing
to borrow and invest more. On the other hand if you
had higher interest rates it would go the other way. Either way you have an
impact on aggregate demand. So with that primer out of the way, let's look at two different
scenarios for an economy. So in this first scenario,
let's call this scenario one, pause the video and think
about where this economy is operating relative to
full employment output. Well you can see here that
our equilibrium level of output, Y sub one, is below
our full employment output. So here we have a negative output gap. And so from the federal
government's point of view they might wanna say, hey
let's do some expansionary fiscal policy in order to shift
the aggregate demand curve to the right. Well what would be
expansionary fiscal policy? Well you could lower taxes. That could shift aggregate
demand to the right. People would have more
money in their pockets. Corporations might have
more money to spend with, to invest with. The other option is that
the government could just directly spend more. If it spends more that
also would have the impact of shifting aggregate demand to the right. But in parallel with the fiscal policy, what might the monetary policy look like? Well an expansionary
monetary policy would be to increase the money supply. Increase the money supply with the goal, which would have the impact, or usually would have the impact, of lowering interest rates which would make borrowing cheaper. And so corporations might invest more and people might borrow and spend more. Either way, or especially
if both is happening, you are going to shift
aggregate demand to the right. So with this expansionary
fiscal and monetary policy you might get to a situation like this. Maybe aggregate demand gets shifted enough so we get to a world like this. So that's aggregate demand curve two. We're now, our equilibrium
level of output, we're at full employment output and our price level has gone, has gone up. And generally speaking,
expansionary policy whether we're talking about
expansionary fiscal policy or expansionary monetary policy, you're going to see the price level go up. Now let's look at scenario two here. What are we dealing with here? Well as you can imagine
it's the opposite situation. We have a positive output gap. Our equilibrium level of output is above our full employment output. And so this is a situation
where the federal government might say, hey our economy
is at risk from overheating. That's typically not what they say. They tend to like it 'cause
it's good for winning election. But they might say, if it's
a prudent federal government, they might say hey this
is the time to maybe pay down some of the government debt. Or be a little bit more
fiscally responsible. And so what they might do is have a contractionary fiscal policy. So that would be taxes
might increase and or government, government
spending might go down. Neither of these things
tend to be very popular. In general contractionary fiscal policy is not a good way to win elections. But a prudent government
might be willing to do this and either of them, because of the same reasons
we just talked about, might have the effect of shifting aggregate demand to the left. Similarly, the Federal
Reserve might wanna do a contractionary monetary policy. And contractionary monetary
policy is far more common. Where the Federal Reserve says, hey when we are producing above
our full employment output inflation might get out of control. So what they might do is
lower the money supply, money supply, which would have the impact, or usually would have the impact, of increasing interest rates
making borrowing more expensive so people might borrow and spend less and corporations might invest less. And so either way you
might have the effect of shifting aggregate demand to the left. So aggregate demand
might look like this now. That's aggregate demand two. Our equilibrium level of output now is at full employment output. And now our price level, our
price level, has gone down. And generally speaking,
contractionary monetary policy and or contractionary fiscal
policy will have the impact of at least slowing down inflation. I'll leave you there. The big takeaway here is, fiscal
policy and monetary policy seldom act in isolation. Oftentimes when we're
at a negative output gap you have expansionary
policies in both dimensions. And in a positive output
gap it might be prudent to have contractionary
policies in both dimensions. Now one question you might ask is what if they go in opposite directions? What if, say, fiscal
policy is expansionary while monetary policy is contractionary? Well there it depends. They might offset each other. In fact, sometimes the
central bank might have a contractionary policy because they think that the federal government
is being too expansionary. All interesting things to think about.