A given fiscal policy means a given path of government
spending and tax rates. A given monetary policy must specify
the implicit monetary policy rule by which interest rates
are set. In this chapter, we assume that is to achieve a given money
supply target.
The IS schedule shows combinations of interest rates and
output compatible with short-run equilibrium output in the goods market. Lower
interest rates boost demand and output. Other causes of shift s in demand
are shown as shift s in the IS schedule.
The LM schedule shows combinations of interest rates and
output compatible with money market equilibrium when the central bank pursues
a money supply target. Higher output is associated with higher interest rates
to maintain the equality of money supply and money demand.
The intersection of IS and LM schedules shows simultaneous equilibrium
in both goods and money markets, jointly determining output and interest rates.
With a given monetary policy, a fiscal expansion increases
output, money demand and interest rates, thus crowding out or
partially displacing private consumption and investment demand.
For a given fiscal policy, a monetary expansion leads
to lower interest rates and higher output.
The mix of monetary and fiscal policy affects the equilibrium
interest rate as well as the level of output.
Ricardian equivalence says that for a given present value
of government spending, the private sector does not care when this is financed
by taxes, since the total present value of taxes is the same. A tax cut today
has no effect on aggregate demand since people anticipate higher future taxes
to finance the extra debt interest.
Ricardian equivalence is only true under extreme assumptions not generally
true in practice. Hence tax cuts today do have some effect today. This effect
is damped by the knowledge that, unless government spending is also cut, future
taxes will have to rise.
Demand management helps stabilize output. Fiscal policy
may be difficult to adjust quickly, and may be difficult politically to reverse
later: much of its impact on aggregate demand thus arises through automatic
stabilizers with an unchanged fiscal policy.
