4.
4 Assignment: The Aggregate Model and
Fiscal/Monetary Policy
Dimple Priyanka Neelam
The importance of the current monetary policy, as well as their impact on GDP and
aggregate demand/aggregate supply, are detailed below. Throughout the history of
money, the consumption habits of many countries have drastically transitioned into
spending most of their earned income on products and services in the economy.
Consequently, governments do not need to intervene to stimulate consumers to spend
their earnings in the economy. The usefulness of economic measures such as GDP
becomes apparent. To ascertain future growth, the government projects the anticipated
economic growth and implements a monetary policy accordingly to complement growth.
It is worth noting that GDP serves as a tool for governments in determining the staggered
combination of taxation and financial spending to stimulate increased spending and
stimulate overall consumption. Once the government formulates a comprehensive
monetary policy, it encourages financial institutions to lower the interest rate to promote
lending activities. Normal households and companies are motivated to spend more,
whether it is on products and services or on new assets. Consequently, consumers and
companies aim to purchase more goods, leading to a marginal increase in income.
1. Monetary Policy Overview:
Interest Rates: Central banks such as the Federal Reserve change interest rates to affect
levels of economic activity.A decrease in rates makes it cheaper to borrow, spurring on
investment and consumption, while higher rates have the opposite effect, cooling down
an overheating economy.
Quantitative Easing (QE): The central bank purchases financial assets to raise the money
supply and lower the interest rate on many long-term bonds, thereby stimulating bond-
financed investment and possibly consumption.
Forward Guidance: Central banks communicate future policy intentions to influence
expectations and economic decisions.
Effects on GDP and Aggregate Demand/Aggregate Supply:
Aggregate Demand (AD): Lower interest rates induce more spending by consumers and
businesses, shifting the AD curve right; QE also drives up AD because it increases the
money supply.
Aggregate Supply (AS) : AD is the key channel for monetary policy, but lower
borrowing rates can also spur capital-goods investment, shifting the AS curve eventually
to the right.
Features of Fiscal Policy Today and Its Effects on Real GDP and Aggregate
Demand/Aggregate Supply
1. Fiscal Policy Overview:
Government spending: Public spending can increase economic activity when
governments spend money on goods and services, and on public infrastructure. During
slumps, debt expenditures can be particularly helpful.
Taxation: Changes in tax rates affect how much income is available for spending for
households, as well as how profitable it is for firms to invest.
Increases in Transfer Payments: transfer payments such as unemployment compensation
and social security redistribute income and may support consumption in the face of
economic shocks.
Effects on GDP and Aggregate Demand/Aggregate Supply:
Aggregate Demand (AD): higher government spending and lower taxes boost
consumption and investment, pushing the AD curve rightward; fiscal consolidation
pushes it left.
Aggregate Supply: Fiscal policy can affect AS by leading to investments in
infrastructure, education and technology so as to enhance potential output and shift the
AS curve to the right over time.
Coordination of Monetary and Fiscal Policies
Current Coordination:
Coordination of monetary and fiscal policy is important, if somewhat rare, when each
policy allows the other to do more to stabilise the economy. In the period of the
pandemic, both policies were highly expansionary, with both monetary and fiscal
culminating in 2020 in a massive effort to stimulate the economy. Central banks, with
interest rates at zero, supplemented QE; governments boosted expenditures and cut taxes.
As a result of these inflationary pressures, monetary policy will tighten, through higher
interest rates, under the Bank’s control, while fiscal policy could turn neutral or even
contractionary, so as not to further worsen inflationary pressures.
Impact on Economic Conditions:
Coordinated response: Combined monetary and fiscal policies have synergistic effects on
the economy. For instance, in a recession, simultaneous stimulative policies have an
enhanced effect on AD, generating a strong economic recovery.
Misalignment: If each of the arrows point in different directions – if policies are
misaligned, as is the case if governments tighten their fiscal policies while central banks
ease monetary policy – then the easing of fiscal policy will be cancelled out by the
contractionary policy of the central bank. Overall, things will turn out worse.
Effects on Aggregate Supply and Demand
Aggregate Demand (AD):
Monetary policy. Lower interest rates and QE boost consumption and investment,
moving AD to the right, while higher rates reduce these expenditures, pushing AD to the
left.
Fiscal Policy: An inward shift in AD is due to a rise in government spending and to cuts
in taxes. An outward shift in AD is the result of fiscal austerity.
Aggregate Supply (AS):
Monetary Policy (monetary policy – same listening exercise as before; you may want to
go back and refresh your notes, before proceeding)The immediate effect is on the AD
curve, but if interest rates are kept low for a long period of time, investments in new
capital and technology can grow. That shifts the AS curve to the right in the long run.
Fiscal Policy: High (in more extreme cases, very high) levels of investment in
infrastructure, education and technology directly stimulate productivity thereby shifting
AS rightward. On the other hand, if there’s been excessive borrowing, then debt levels
can eventually push up interest rates, which depresses private investment and might
curtails AS growth.
Summary:
Current policies: monetary policy is temporarily tightening as part of the surge in
inflation; fiscal policy is neutral or mildly contractionary.
Co-ordination: Economic policies work well or badly on the basis of how they are
currently co-ordinated. They appear to be co-ordinated to reduce inflation, for example,
but might need adjusting if economic conditions change.
Impacts: Both monetary and fiscal policies tilt AD roughly proportional to their scale,
with long-run effects on AS through investment in productivity and technology.
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