AP® Macroeconomics review sheet from Aim for Five (aimforfive.com/macro/units/5/5-1)
Unit 5 · Topic 5.1
5.1 Fiscal and Monetary Policy Actions in the Short Run
Fiscal policy (government spending and taxes) and monetary policy (central bank interest rate actions) can work together to close an output gap, or they can pull in opposite directions. To analyze any mix, trace each policy's effect on AD, real GDP, the price level and interest rates one at a time, then combine them.
Key terms
- expansionary policy
- contractionary policy
- recessionary (negative) output gap
- inflationary (positive) output gap
- AD–AS model
The two kinds of stabilization policy
Both kinds of policy work by shifting AD. Expansionary policy shifts AD right; contractionary policy shifts it left.
| Policy | Who acts | Expansionary tools | Contractionary tools |
|---|---|---|---|
| Fiscal | The government (lawmakers) | Raise government spending, cut taxes or raise transfer payments | Cut government spending, raise taxes or cut transfer payments |
| Monetary, limited reserves | The central bank | Buy bonds, lower the reserve ratio or lower the discount rate | Sell bonds, raise the reserve ratio or raise the discount rate |
| Monetary, ample reserves | The central bank | Lower interest on reserves and other administered rates | Raise interest on reserves and other administered rates |
Matching the policy to the gap
On an AD–AS graph (price level on the vertical axis, real GDP on the horizontal), a recessionary gap shows AD crossing SRAS to the left of the vertical LRAS line. Expansionary policy shifts AD right until the intersection reaches LRAS: real GDP rises to full employment and the price level rises. An inflationary gap is the mirror image, with the intersection to the right of LRAS.
- Recessionary (negative) output gap: real GDP is below full employment, and unemployment is above its natural rate. Use expansionary fiscal policy, expansionary monetary policy, or both.
- Inflationary (positive) output gap: real GDP is above full employment, and unemployment is below its natural rate. Use contractionary fiscal policy, contractionary monetary policy, or both.
Tracing a policy mix
When two policies act at once, analyze them one at a time, then combine. If both push a variable the same way, the result is clear. If they push opposite ways, the result is indeterminate (it depends on which effect is bigger) unless the question gives sizes.
Why does fiscal policy move interest rates? Expansionary fiscal policy raises real GDP and the price level, which increases money demand and pushes up the nominal interest rate. If it's paid for by borrowing, it also raises the demand for loanable funds and the real interest rate (5.5). Monetary policy moves the interest rate directly.
| Policy mix | AD | Real GDP and price level | Interest rate |
|---|---|---|---|
| Expansionary fiscal + expansionary monetary | Increases | Both rise | Indeterminate |
| Contractionary fiscal + contractionary monetary | Decreases | Both fall | Indeterminate |
| Expansionary fiscal + contractionary monetary | Indeterminate | Indeterminate | Rises |
| Contractionary fiscal + expansionary monetary | Indeterminate | Indeterminate | Falls |
Why combine them?
A mix can close a gap while limiting side effects. Expansionary fiscal policy alone may push up interest rates and crowd out some private investment; pairing it with expansionary monetary policy can keep rates from rising.
The two also differ in timing. Fiscal policy usually needs new laws, which can take months to pass. A central bank can change rates at one meeting, though its effects on spending take time to build. Economists and policymakers debate the best mix in practice. On the exam, predict what the models say, not which policy is better.
Worked examples
Try each one yourself first, then open the solution.
- Example 1Calculator allowed
How big a spending change?
An economy's real GDP is $400 billion below full-employment output, and the marginal propensity to consume (MPC) is 0.8. Assuming no crowding out, what's the minimum increase in government spending that could close the gap? What tax cut would close it instead?
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- Step 1: Spending multiplier = 1 ÷ (1 − MPC) = 1 ÷ (1 − 0.8) = 1 ÷ 0.2 = 5.
- Step 2: Needed increase in government spending = gap ÷ spending multiplier = $400 billion ÷ 5 = $80 billion.
- Step 3: Tax multiplier = −MPC ÷ (1 − MPC) = −0.8 ÷ 0.2 = −4. A tax cut raises spending by 4 times its size.
- Step 4: Needed tax cut = $400 billion ÷ 4 = $100 billion. It's larger than the spending change because people save part of any tax cut before they spend it.
Answer: An $80 billion increase in government spending, or a $100 billion tax cut.
- Example 2
Both policies at once
An economy with limited reserves is in a recessionary gap. The government raises its spending, and the central bank buys government bonds. What happens to AD, real GDP, the price level and the nominal interest rate?
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- Step 1: Fiscal: more government spending shifts AD right. Higher income and prices raise money demand, which pushes the nominal interest rate up.
- Step 2: Monetary: buying bonds shifts MS right, which pushes the nominal interest rate down, raises investment and shifts AD right.
- Step 3: Combine: both shift AD right, so AD, real GDP and the price level all rise.
- Step 4: The two policies push the interest rate in opposite directions, so the change in the interest rate is indeterminate without more information.
Answer: AD, real GDP and the price level increase; the change in the nominal interest rate is indeterminate.
- Example 3
Policies pulling apart (classic trap)
The government cuts taxes. At the same time, the central bank, worried about inflation, raises interest on reserves in an ample-reserves system. A student says real GDP must rise because taxes fell. Evaluate the claim.
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- Step 1: Fiscal: the tax cut raises disposable income and consumption, so AD shifts right.
- Step 2: Monetary: higher interest on reserves raises the policy rate and other interest rates, which lowers investment and interest-sensitive consumption, so AD shifts left.
- Step 3: The two AD effects work against each other, so the change in real GDP is indeterminate.
- Step 4: Interest rates are clear, though: the tax cut tends to raise them and the monetary action raises them, so interest rates rise.
Answer: The student is wrong: the change in real GDP is indeterminate, but interest rates rise.
Common mistakes
- Giving a definite direction when two policies push a variable opposite ways. Say the result is indeterminate unless the question gives sizes.
- Assigning tools to the wrong policymaker. The central bank doesn't set taxes or government spending, and the government doesn't buy bonds to change the money supply.
- Using the spending multiplier for a tax change. The tax multiplier is smaller in size: −MPC ÷ (1 − MPC).
- Forgetting the price level. Expansionary policy that closes a recessionary gap raises real GDP and the price level.
On the exam
- Long free-response questions often start with an economy in a gap, ask for the right fiscal or monetary action, then ask what happens to real GDP, the price level and the interest rate. Give a direction and a reason for each.
- When a question asks for the minimum change in spending or taxes, divide the output gap by the right multiplier and show the formula.
Connected topics
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Check yourself
4 questions on 5.1 Fiscal and Monetary Policy Actions in the Short Run. Pick an answer to see if you got it, and why.
Country R is in a recessionary gap: real GDP is below full-employment output.
Its government increases spending on highways and borrows to pay for it. At the same time, its central bank, which operates with limited reserves, buys government bonds on the open market.
Hypothetical scenario
What is the combined short-run effect of these two policies on aggregate demand and real GDP?
What is the combined effect of the two policies on interest rates?
Suppose that a few years later, Country R faces an inflationary gap instead. Which pair of policies would both work to close it?
A government raises taxes to shrink its budget deficit. At the same time, the central bank lowers interest rates. Which of the following is certain?
0 of 4 answered