Effect of Monetary Policy, Fiscal Policy and Monetray-Fiscal Policies Mix on Equilibrium Income

Monetary policy and effect on equilibrium income

Monetary policies are introduced by the central bank to control the money supply and instrument for achieving the goals of general economic policy. In simple terms, it can be defined as the management of the expansion and contraction of the volume of money in circulation. There are two types of monetary policies:

Expansionary monetary policy

This policy is introduced in the economy to expand the money supply and credit in an economy. Some of the techniques used to expand the money supply in the economy are:

• Purchase of bonds and treasury bills in the open market
• Lowering the discount rate or bank rate
• Lowering the Required Reserve Ratio (RRR)

Effect of expansionary monetary policy on equilibrium income

The increase in money supply in the economy has a positive impact on the income because the increase in real money supply over real money demand causes interest rate to fall in order to restore money market equilibrium. When interest rate decreases, the income increases by stimulating investment. The increase in money supply shifts the LM curve to the right.

In the figure above, when money supply increases, the LM curve shifts right where interest rate decreases from r₀ to r₁ and income increases from Y₀ to Y₁.

Contractionary monetary policy

Contractionary monetary policy is introduced in the economy to control the money supply by lowering the demand for consumption and investment. The objective of such policy is to decrease aggregate demand. Some of the techniques used to decrease money supply in the economy are:

• Selling the bonds, securities and treasury bills in the open market.
• Increasing the discount rate,
• Raising the minimum required reserve ratio.

Effect of contractionary monetary policy on equilibrium income

The decrease in money supply in the economy has a negative impact on the income because the decrease in real money supply over real money demand causes interest rate to rise in order to restore money market equilibrium. When interest rate increases, the income decreases. The decrease in money supply shifts the LM curve to the left.

In the figure above, when money supply decreases, the LM curve shifts left where interest rate increases from r_o to r₁ and income decreases from Y₀ to Y₁.

Fiscal Policy and effect on equilibrium income

Fiscal policy is concerned with government revenue and expenditure. It is also called the budgetary policy. It controls the budget and tries to maintain the economy in equilibrium. Fiscal policies are of two types:

Expansionary fiscal policy

The expansionary fiscal policy is applied when there is budget deficit i.e. when spending is higher than revenue. In expansionary fiscal policy, the government reduces the tax rate or increases the government expenditure. The objective of the expansionary fiscal policy is to stimulate the economy and increase aggregate expenditure and national income.

Effect of expansionary fiscal policy on equilibrium income

When the government decreases tax, a number of disposable income increases which increases consumption and hence the demand for goods and output increases. An expansionary fiscal policy, therefore, increases the interest rate and the level of output and income in the IS-LM model for a closed economy. As a result, the IS curve shifts rightward.

When the tax decreases, the output increases from Y₀ to Y₁ and interest rate increases from r₀ to r₁.

Contractionary fiscal policy

The contractionary fiscal policy is applied when there is budget surplus i.e. when revenue is higher than spending. In contractionary fiscal policy, the government increases tax rate or reduces public expenditure. The objective of the contractionary fiscal policy is to stimulate the economy and decrease aggregate expenditure.

Effect of contractionary fiscal policy on equilibrium income

When the government increases the tax, it will lead to a flatter slope of the IS curve resulting in a lower level of income in the economy because the higher taxes reduces consumer income and therefore causes consumption to fall as well.

In the figure above, when the tax increases, the IS curve shifts from IS to IS₁. It leads to decrease in income level from OY₀ to OY₁ causing interest rate to decrease from r₀ to r₁ and income also decreases from Y₀ to Y₁.

Monetary – Fiscal Policies mix and effect on equilibrium income

The combination of fiscal and monetary policy is widely used to solve various economic problems. Let us see the combined effect of various monetary and fiscal policies in equilibrium income.

Effect on equilibrium with expansionary monetary policy and contractionary fiscal policy

To raise investment while keeping output constant, the government should adopt a loose monetary policy and a tight fiscal policy, as shown in the figure below. In the new equilibrium at point B, the interest rate is lower, so that investment is higher. The tight fiscal policy—reducing government purchases, for example—offsets the effect of this increase in investment on output.

Effect on equilibrium with contractionary monetary policy and expansionary fiscal policy

To lower investment while keeping output constant, such policy mix is appropriate. This policy mix shifts the IS curve to the right and the LM curve to the left, as in the figure below. The real interest rate rises and investment falls.

References

Dwivedi, D. N. (2010). Macroeconomic theory and policy. New Delhi: Tata McGraw-Hill Education.

Bernake and Abel, Macroeconomics, Singapore, Pearson Education latest edition