Fiscal and monetary policy in parallel | AP Macroeconomics | Khan Academy

In previous videos, we have talked at length about fiscal policy, and in other videos, we've talked at length about monetary policy. But now we're going to talk about them together. Because at any given time in a country, there is some type of fiscal policy going on, and in parallel, there might be some type of monetary policy going on.

But first, let's just remind ourselves what fiscal policy is. This would be government changing the amount of taxes or government spending. So this is all about taxes and/or government spending. And why would that matter? Well, if you change the amount of taxes, you change the amount of money that individuals and/or corporations might have, which might change aggregate demand. Similarly, if the government goes out there and spends more or less, that also would change aggregate demand. This could be used as a tool in order to attempt to engineer what the economy's output is.

Now, monetary policy, on the other hand, it's very important not to get confused between these two. This is all about central banks. I know a lot of you might be thinking, "Hey, isn't the central bank part of the government?" I would tell you, well, it depends on what country you're in and depends on how you view part of the government. In the United States, for example, the Federal Reserve System is quasi-independent. It is true that the executive makes appointments, including the chairman of the Federal Reserve Bank, but it should be acting independently from the federal government.

This is all about central banks changing the money supply. So, money supply to impact or to target oftentimes interest rates. Now, why would this matter if we're thinking about engineering, so to speak, where we are relative to full employment output? Well, with low interest rates, borrowing is cheaper. So, people might be willing to borrow and spend more, or corporations might be willing to borrow and invest more. On the other hand, if you had higher interest rates, it would go the other way. Either way, you have an impact on aggregate demand.

So, with that primer out of the way, let's look at two different scenarios for an economy. In this first scenario, let's call this scenario one. Pause the video and think about where this economy is operating relative to full employment output. Well, you can see here that our equilibrium level of output Y sub one is below our full employment output. So here, we have a negative output gap. From the federal government's point of view, they might want to say, "Hey, let's do some expansionary fiscal policy in order to shift the aggregate demand curve to the right."

Well, what would be expansionary fiscal policy? Well, you could lower taxes; that could shift aggregate demand to the right. People would have more money in their pockets, and corporations might have more money to spend with to invest with. The other option is that the government could just directly spend more. If it spends more, that also would have the impact of shifting aggregate demand to the right.

But in parallel with the fiscal policy, what might the monetary policy look like? Well, an expansionary monetary policy would be to increase the money supply, with the goal of usually having the impact of lowering interest rates, which would make borrowing cheaper. Corporations might invest more, and people might borrow and spend more. Either way, or especially if both are happening, you are going to shift aggregate demand to the right.

So, with this expansionary fiscal and monetary policy, you might get to a situation like this. Maybe aggregate demand gets shifted enough so we get to a world like this. So, that's aggregate demand curve 2. We're now at our equilibrium level of output, we're at full employment output, and our price level has gone up. Generally speaking, expansionary policy, whether we're talking about expansionary fiscal policy or expansionary monetary policy, you're going to see the price level go up.

Now, let's look at scenario two. Here, what are we dealing with? Well, as you can imagine, it's the opposite situation. We have a positive output gap. Our equilibrium level of output is above our full employment output. This is a situation where the federal government might say, "Hey, our economy is at risk from overheating." That's typically not what they say; they tend to like it because it's good for winning elections. But they might say, if it's a prudent federal government, they might say, "Hey, this is a time to maybe pay down some of the government debt or be a little bit more fiscally responsible."

So, what they might do is have a contractionary fiscal policy. This would mean taxes might increase and/or government spending might go down. Neither of these things tend to be very popular. In general, contractionary fiscal policy is not a good way to win elections, but a prudent government might be willing to do this. Either of them, because of the same reasons we just talked about, might have the effect of shifting aggregate demand to the left.

Similarly, the Federal Reserve might want to do a contractionary monetary policy. Contractionary monetary policy is far more common, where the Federal Reserve says, "Hey, when we are producing above our full employment output, inflation might get out of control." So, what they might do is lower the money supply. This would have the impact or usually would have the impact of increasing interest rates, making borrowing more expensive. So, people might borrow and spend less, and corporations might invest less. Either way, you might have the effect of shifting aggregate demand to the left.

So, aggregate demand might look like this. Now, that's aggregate demand two. Our equilibrium level of output now is at full employment output, and now our price level has gone down. Generally speaking, contractionary monetary policy and/or contractionary fiscal policy will have the impact of at least slowing down inflation.

I'll leave you there. The big takeaway here is fiscal policy and monetary policy seldom act in isolation. Oftentimes, when we're at a negative output gap, you have expansionary policies in both dimensions. In a positive output gap, it might be prudent to have contractionary policies in both dimensions.

Now, one question you might ask is, "What if they go in opposite directions? What if, say, fiscal policy is expansionary while monetary policy is contractionary?" Well, there, it depends. They might offset each other. In fact, sometimes the central bank might have a contractionary policy because they think that the federal government is being too expansionary. All interesting things to think about.