Fiscal and Monetary Policy

by Jessica, Naah, and Star

What is Fiscal Policy?

Fiscal Policy is the deliberate changes in government spending and net tax collection to affect economic output, unemployment, and the price level.

Why do we need Fiscal Policy?

Governments use fiscal policy to promote strong and sustainable growth and reduced poverty. This policy is used to influence the economy.

It's purpose:

  • To stimulate economic growth in a period of recession
  • Keep inflation low
  • Stabilize growth
  • Avoids problems in the economic cycle

Types of Fiscal Policy

  • Expansionary- goal is to fight a recession. It increases aggregate demand. Expands government budget deficit which will lead to increase borrowing.
  • Contractionary- lower government spending or higher net taxes to shift AD to the left to full employment, and reduce inflationary pressures.

In contractionary fiscal policy to get rid of an inflationary gap the government must reduce government spending and increase taxes.

In expansionary fiscal policy to get an economy out of recession the government would have to increase government spending and lower taxes.

What is Monetary Policy?

Monetary policy is one of the way that the U.S. government attempts to control the economy. If the money supply grows to fast the rate of inflation will increase; if the growth of the money supply is slowed too much then the economic growth may also slow.


  • The maximum, or simple, money multiplier M=1/rr.
  • An initial amount of excess reserves multiplies by, at most, a factor of M.

Why do we need Monetary Policy?

Monetary policy is maintained through actions such as increasing the interest rate or changing the amount of money banks need to keep in the vault (bank reserves).

Types of Monetary Policy

  • Expansionary- it's designed to fix a recession and increase aggregate demand, lowering unemployment rate, and increasing real GDP. By increasing the money supply , the interest rate is lowered. A lower rate of interest increases private consumption and investment, which shifts the aggregate demand curve to the left. On page 149 in the 5 Steps to a Five book, Figures 11.5 and 11.6 show the process.
  • Contractionary- its designed to avoid inflation by decreasing aggregate demand. It will lower the price level and increase GDP to full employment; it will decrease money supply and increase the interest rate.

Quick Review:


Holding money balances serves as a way of protecting one's assets from the affects of inflation.

Which of the following correctly describes equilibrium in the money market?

A) output equals Natural Real GDP and the price level is constant.

B) aggregate supply equals long-run aggregate supply

C) an interest rate at which the quantity of money demanded equals the quantit supplied

D) none of the above

When does a recessionary gap occur?

A) when potential GDP exceeds real output

B) real output exceeds potential output

C) nominal output exceeds potential GDP

D) All of the above

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