Monetary
&
Fiscal Policy
Presented by:
Amit Gunjan 22/51010
Ansh Raj 22/51012
Harshit Tuteja 22/51049
Monetary Policy
What is Monetary Policy?
Definition:
Monetary policy refers to the actions taken by a country's central
bank to control the money supply, interest rates, and inflation to
ensure economic stability and growth.
Key Features:
•Implemented by the Central Bank (like RBI, Federal Reserve).
•Aims to control inflation and stabilize prices.
•Supports economic growth and employment.
•Uses tools like interest rates, open market operations, and reserve requirements.
•Adjusts the money supply in the economy.
Example:
If inflation is rising too much, the central bank can increase interest
rates to make borrowing expensive and slow down spending.
Monetary Policy & Central Bank
The central bank manages the money supply through monetary
policy. This policy is primarily implemented using Open Market
Operations (OMOs), where the central bank buys and sells
government bonds to influence the economy.
•Buying Securities: The central bank buys government securities from
banks.
Effect: This increases bank reserves and lowers interest rates.
Result: Lower interest rates make borrowing cheaper, which increases the
money supply as people and businesses borrow more.
•Selling Securities: The central bank sells government securities to banks.
Effect: This reduces bank reserves and raises interest rates.
Result: Higher interest rates make borrowing more expensive, reducing the
money supply as borrowing decreases.
Graphical Explanation
Initial Equilibrium (Point E):
Before the central bank conducts open market operations, the economy is at
equilibrium at point E. This point reflects the initial level of interest rates (i) and
income/output (Y).
The LM curve represents the relationship between the money supply, interest
rates, and income.
Open Market Purchase of Bonds:
When the central bank buys bonds, it increases the money supply. This is
represented by a shift in the LM curve from LM to LM'.
The increase in the money supply leads to a higher level of real money supply (M/P),
which causes the interest rates to fall. With more money available in the economy,
borrowing becomes cheaper.
New Equilibrium (Point E'):
After the LM curve shifts to the right (from LM to LM'), the economy reaches a new
equilibrium at point E'. At this point:
Interest rates are lower.
Income (Y) is higher.
This happens because lower interest rates stimulate investment spending, which in
turn increases economic output.
Impact of Money Demand on the Shift
Steeper LM Curve (Low Sensitivity to Interest Rates):
A small increase in the money supply leads to a larger decrease in interest rates.
This causes a significant increase in investment and income.
Flatter LM Curve (High Sensitivity to Interest Rates):
A larger increase in the money supply leads to a smaller decrease in interest rates.
The effect on investment and income is minimal.
Adjustment to Monetary Expansion
1. Initial Effect:
At equilibrium point E, the increase in the money supply creates an excess supply of money.
The public adjusts by buying other assets, causing asset prices to rise and yields to decline.
2. Money Market Adjustment:
The economy moves quickly to point E₁, where the money market clears and the public holds
the larger real money supply as interest rates fall.
3.Excess Demand for Goods
As interest rates decline, aggregate demand rises, depleting inventories and increasing output.
This causes a shift up along the LM' curve.
The Transmission Mechanism
Monetary policy changes, like adjustments to the money supply, affect
aggregate demand and output through two main steps:
1. Portfolio Disequilibrium → Change in Interest Rates
Increased Money Supply → People hold more money than desired.
Adjustment: To balance, they buy assets, causing:
•Asset prices to rise
•Interest rates to fall
2. Change in Interest Rates → Change in Aggregate Demand
Lower Interest Rates lead to:
Higher investment spending
Increased consumption
Higher business/government spending
Result: Aggregate demand and output (income level Y) rise.
The Liquidity Trap
Definition: A situation where the public is willing to hold any amount
of money at a given interest rate, leading to a horizontal LM curve.
Key Points:
In the liquidity trap:
Monetary policy has no effect: Changes in the money supply do
not affect interest rates or income levels.
Interest rates remain unaffected despite changes in the money
supply.
Implications:
When interest rates are near zero, monetary policy becomes ineffective
because the LM curve flattens, making it hard for further monetary
expansion to have an impact.
Fiscal Policy
What is Fiscal Policy?
Fiscal policy refers to the strategic use of
government spending and taxation to influence a
nation’s economic activity. It plays a critical role in
managing economic fluctuations, aiming to
stabilize output levels, control inflation, and
reduce unemployment. Fiscal policy remains one
of the most important tools available to
policymakers for steering both short-term and
long-term economic outcomes.
What is Expansionary Fiscal
Policy?
Expansionary fiscal policy involves actions taken by the
government to increase aggregate demand in the economy.
Methods include:
Increasing government expenditure (e.g., building roads,
providing subsidies)
Decreasing taxes (e.g., lower income or corporate taxes)
Effect of Expansionary Fiscal
Policy
When the government increases spending or cuts taxes:
Aggregate demand increases.
Consumption and investment rise.
Output (Y) increases at any given interest rate.
Impact on the IS Curve
Expansionary fiscal policy causes the IS curve to shift
rightward.
For each level of interest rate, the economy now produces a
higher level of output.
The new equilibrium is at higher GDP and possibly at a
higher or same interest rate depending on monetary
conditions.
Expansionary fiscal policy works
by boosting overall spending:
Firms see higher demand → Increase production
Workers are hired → Higher employment and income
Further increases demand, creating a positive
feedback loop.
Crowding Out
When the government increases spending, income (output)
rises but interest rates also increase.
This rise in interest rates makes borrowing costlier, causing
private investment to fall.
This negative effect on investment is called crowding out.
Comparing Points E, Eʺ, and Eʹ:
E = Starting point (original equilibrium).
Eʺ = Where the economy would go if interest rates didn’t change (bigger
increase in income).
Eʹ = The actual new equilibrium after government spending increases
and interest rates rise (smaller increase in income).
Thus, because interest rates rise, income only rises to Yʹ0, not to Yʺ.
What Determines How Much Crowding Out Happens?
It depends on the shapes of the IS and LM curves and the size of
the multiplier:
Factor Effect
Flatter LM curve Income increases more, interest rates rise less →
Less crowding out
Flatter IS curve Income increases less, interest rates rise less →
Also less crowding out
Bigger Multiplier (αG) Bigger shift of IS curve → More
pressure on interest rates → More crowding out
General Rule:
More rise in interest rates → More crowding out.
Less rise in interest rates → Less crowding out.
Liquidity Trap (Horizontal LM Curve)
In a liquidity trap, the LM curve is horizontal — meaning interest rates
don't change even if government spending goes up.
So when the government spends more, income/output goes up fully
— there's no rise in interest rates, and no fall in private investment.
Result:
➔ Fiscal policy (like government spending) works very strongly.
➔ Monetary policy (changing money supply) doesn't work at all
(because interest rates are stuck).
Example:
Imagine you're pouring more water into a flat tray — the water
spreads easily without getting "stuck" anywhere (no barriers =
no interest rate rise).
Classical Case (Vertical LM Curve)
In the Classical case, the LM curve is vertical — meaning
income/output cannot change, no matter what.
When the government spends more, interest rates rise but income
stays the same.
Result:
➔ Higher interest rates cause private investment to fall.
➔ The amount by which government spending goes up is exactly
cancelled by how much private investment goes down.
This is called "full crowding out" — government spending pushes out
private investment completely.
Example:
Imagine you're trying to add more people into an elevator that's
already full — if one person enters, another has to leave.
THANK YOU
FOR YOUR NICE ATTENTION
