Lecture 13 - Monetary and Fiscal Policy
1. Macroeconomic Fluctuations and the AD-AS Framework
Macroeconomists use the Aggregate Demand–Aggregate Supply (AD–AS) model to analyse short-run economic fluctuations and the potential role of policy in stabilising the economy.
The model combines:
- Demand-side forces: consumption, investment, government spending, and net exports.
- Supply-side forces: production costs, expectations, technology, and labour market conditions.
Economic activity can deviate from its long-run level due to shocks to demand or supply. Governments and central banks may respond using policy tools designed to stabilise output and employment.
Aggregate Demand (AD): The total quantity of goods and services demanded in the economy at each price level.
Aggregate Supply (AS): The total quantity of goods and services firms are willing to produce at each price level.
2. Long-Run Macroeconomic Equilibrium
The economy is in long-run equilibrium where the AD curve intersects the LRAS curve.
At this point:
- Output equals natural output (
- Expected price level equals the actual price level.
- The SRAS curve also passes through the same point.
This represents a situation where expectations about prices and wages are correct.
Long-run equilibrium reflects the classical macroeconomic idea that output is determined by real factors such as capital, labour, and technology. Nominal variables such as the price level adjust so that aggregate demand equals this supply-determined level of output.
When expectations are correct, firms and workers set prices and wages optimally. There are no unexpected price movements that distort production decisions.
Key properties of long-run equilibrium:
- Unemployment equals the natural rate
3. Demand-Driven Economic Fluctuations
Aggregate Demand Contraction
A demand-driven recession occurs when the aggregate demand curve shifts left.
Possible causes include:
- Consumer pessimism
- Stock market crashes
- Falling exports during foreign recessions
- Contractionary monetary policy
Short-Run Effects
When AD shifts from
- Output falls:
- Employment falls
- Price level declines:
The economy moves along the SRAS curve from point A to B.
Long-Run Adjustment
Over time:
- Expected prices adjust downward.
- The SRAS curve shifts right.
- Output returns to natural output
The economy eventually reaches a new equilibrium at point C.
Firms initially set wages and prices based on expectations formed earlier. When demand collapses unexpectedly, firms reduce output because they cannot immediately adjust wages and expectations.
The key expectations channel operates through wage-setting behaviour. If actual prices fall below expected prices (
Exam trigger: “Explain how a negative demand shock affects output and prices in the short run and long run using the AD–AS model.”
4. Supply-Driven Economic Fluctuations
Negative Supply Shock
A negative supply shock occurs when the SRAS curve shifts left due to higher production costs.
Possible causes include:
- Energy price shocks
- Wage pressures
- Supply chain disruptions
- Regulatory changes
Short-Run Effects
When SRAS shifts left:
- Output falls:
- Price level rises:
This situation is known as stagflation.
Stagflation: A macroeconomic condition where inflation rises while output and employment decline.
Higher production costs force firms to both reduce output and increase prices simultaneously.
Pitfall: Not all recessions reduce inflation. Supply-driven recessions typically increase inflation.
Demand shocks → recession with falling prices
Supply shocks → recession with rising prices
5. Economic Expansions
Economic expansions occur when either:
- Aggregate demand shifts right
- Aggregate supply shifts right
Demand-Driven Expansions
Examples include:
- Wartime government spending in the early 1940s.
- Post-pandemic fiscal stimulus.
Mechanism:
- Government spending increases.
- Aggregate demand rises.
- Output and employment expand.
Supply-Driven Expansions
These occur when productive capacity increases due to:
- Technological innovation
- Productivity improvements
- Capital accumulation
Example: the technology boom of the 1990s.
Supply-driven expansions shift productive capacity outward and can eventually move the LRAS curve to the right.
6. Accommodating a Negative Supply Shock
Policymakers may respond to a supply shock by shifting aggregate demand to the right.
Policy objective:
- Prevent the decline in output and employment.
Result:
- Output returns to natural output more quickly.
- Price level increases permanently.
This creates a policy trade-off between stabilising output and controlling inflation.
Policymakers face a stabilisation trade-off. Increasing demand reduces unemployment but exacerbates inflation.
Exam trigger: “Discuss the policy trade-off involved in responding to stagflation.”
7. Policy Instruments for Influencing Aggregate Demand
Governments influence aggregate demand using two main tools:
- Monetary policy
- Fiscal policy
Both policies aim to stabilise the economy during recessions and booms.
8. Monetary Policy
Monetary policy works through changes in the money supply and interest rates.
Expansionary Monetary Policy
If the central bank increases the money supply:
- Interest rates fall.
- Investment spending increases.
- Aggregate demand rises.
The transmission mechanism can be summarised as:
Contractionary Monetary Policy
If the central bank reduces the money supply:
- Interest rates increase.
- Borrowing falls.
- Aggregate demand decreases.
Monetary policy operates through the interest rate channel, influencing investment and consumption decisions.
Monetary Policy Instruments
Central banks typically influence interest rates using:
- Policy interest rates (Bank Rate)
- Open market operations
- Asset purchases or sales
Changing interest rates and changing money supply are effectively two sides of the same policy instrument.
9. Fiscal Policy
Fiscal policy involves government decisions regarding:
- Public spending
- Taxation
Expansionary fiscal policy shifts AD right.
Contractionary fiscal policy shifts AD left.
However, the ultimate effect depends on two opposing forces:
- Multiplier effect
- Crowding-out effect
10. The Multiplier Effect
The multiplier effect describes how an increase in government spending leads to a larger increase in total demand.
Example:
- Government increases spending by £20 billion.
- Income rises.
- Households increase consumption.
- Firms increase production and investment.
This creates a chain reaction of additional spending.
Marginal Propensity to Consume
Marginal Propensity to Consume (MPC): The fraction of additional income that households spend.
Higher MPC → larger multiplier.
When households spend most of their extra income, new spending circulates repeatedly through the economy, amplifying the initial demand shock.
11. The Crowding-Out Effect
The crowding-out effect occurs when government spending increases interest rates and reduces private investment.
Mechanism:
- Government spending increases income.
- Higher income increases money demand.
- Interest rates rise.
- Investment falls.
This partially offsets the fiscal expansion.
The crowding-out effect reflects interactions between fiscal policy and financial markets. Higher interest rates reduce private sector investment.
Net impact of fiscal expansion depends on:
- Size of multiplier effect
- Strength of crowding-out
12. Active Stabilisation Policy
Active stabilisation policy: The use of fiscal and monetary policy to stabilise output and employment in response to economic shocks.
The objective is to maintain:
- Full employment
- Stable inflation
13. Debate Over Stabilisation Policy
Keynesian Perspective
Keynesians argue that:
- Aggregate demand drives short-run fluctuations.
- Governments should actively stabilise demand.
- Fiscal stimulus can reduce unemployment during recessions.
Arguments Against Active Policy
Critics argue:
- Policy operates with long and variable lags.
- Economic forecasts may be incorrect.
- Policy mistakes can cause inflation or asset bubbles.
- Government intervention may introduce inefficiency or corruption.
Pitfall: Assuming policy can perfectly stabilise the economy. In reality, implementation lags and forecasting errors limit effectiveness.
14. The Great Recession (2008–2009)
The global financial crisis caused a major contraction in aggregate demand.
Key outcomes:
- Real GDP fell by about 4%.
- Unemployment rose from 4.4% to 10.1% in the US.
- Financial markets experienced severe disruptions.
15. Policy Responses to the Crisis
Governments and central banks implemented major interventions.
Monetary Policy
Central banks:
- Cut interest rates close to zero.
- Purchased government bonds and financial assets.
- Provided liquidity to banks.
Financial Sector Support
Governments:
- Injected capital into banks.
- Provided emergency loans.
- Temporarily nationalised parts of the banking sector.
Fiscal Stimulus
In the United States:
- A $787 billion fiscal stimulus package was implemented in 2009.
These policies aimed to restore aggregate demand and stabilise the financial system.
Exam trigger: “Discuss the policy responses to the 2008 financial crisis using the AD–AS framework.”
16. Automatic Stabilisers
Automatic stabilisers: Government mechanisms that automatically stabilise aggregate demand without discretionary policy changes.
Examples:
- Progressive taxation
- Unemployment benefits
- Welfare payments
During recessions:
- Tax revenue falls.
- Transfer payments rise.
Both effects increase aggregate demand automatically.
Automatic stabilisers inject spending into the economy during downturns and withdraw spending during booms.
Key features:
- Operate automatically
- Reduce volatility in output and employment
- Strength depends on size of government sector
Bibliography
Mankiw, N. G. and Taylor, M. P. (2023) Macroeconomics. 6th edn. Andover: Cengage Learning EMEA.
Jensen, M. K. (2026) ECON1002 Introduction to Macroeconomics Lecture Slides: Monetary and Fiscal Policy. University of Nottingham.
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