David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 20 Monetary and fiscal policy
quantity of narrow money can imply very different quantities of broad money. It is much simpler for
central banks to decide what interest rate they wish to set, and then passively supply whatever narrow
money is necessary to get whatever quantity of broad money is needed for money market equilibrium at
that interest rate.
II
The monetary fiscal mix
Consider the model:
Y=A-br
Y=D+er
IS schedule
LM schedule
Hence, Y =A - br = D + er, so in short-run equilibrium:
A, b>O
e>O,OO
Y = [mR +hr] If= [mR!f] + (hlf) r
Comparing this with equation (lb), we can see that the constant D in the LM schedule, which determines
how far to the right the LM schedule lies, is just [mR!f] and will increase if the central bank supplies more
reserves R, if banks raise the deposit multiplier m, or if money demand becomes more sensitive to income via
the parameter f Moreover, the slope of the schedule, which depends on e in equation ( 1 b), simply depends
on the parameters h and f
(3)
..,
The policy mix
_ _ _ _ _
Fiscal policy is government decisions about tax rates and spending levels. Changes in fiscal policy shift the
IS schedule. Changes in monetary policy shift the LM schedule.
We now explore consequences of different IS and LM schedules (different monetary and fiscal policies).
Budget deficits can be financed by printing money or by borrowing. In the latter case, there is no short-run
connection between monetary and fiscal policy provided the government is solvent and can borrow any
reasonable amount that it wishes. The government can then pursue independent monetary and fiscal
policies.
Although both fiscal and monetary policy can alter aggregate demand, the two policies are not
interchangeable. They affect aggregate demand through different routes and have different implications for
the composition of aggregate demand.
Figure 20.6 shows the mix of monetary and fiscal policy. There are two ways to stabilize income at Y*. First,
there is expansionary or easy fiscal policy (high government spending or low tax rates). This leads to a high
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