Fiscal policy and monetary policy are set by different people: lawmakers and the central bank. Often both act at once. To predict the result, work out each policy's effects on its own, then combine them.
Key idea
When two policies push a variable the same way, the direction is clear. When they push it in opposite ways, the result is indeterminate: it depends on which effect is larger. Fiscal expansion raises AD and tends to raise interest rates; monetary expansion raises AD and lowers interest rates.
Why it works
Each policy moves AD, and fiscal policy also pushes up interest rates (more spending and income raise money demand, and government borrowing competes for saving), while monetary policy moves interest rates directly. Stack the arrows. If both shift AD right, output and the price level rise for sure, but the interest rate gets one push up and one push down, so without sizes you cannot say which way it goes.
| Fiscal | Monetary | Real GDP | Price level | Interest rate |
|---|---|---|---|---|
| Expansionary | Expansionary | up | up | indeterminate |
| Expansionary | Contractionary | indeterminate | indeterminate | up |
| Contractionary | Expansionary | indeterminate | indeterminate | down |
| Contractionary | Contractionary | down | down | indeterminate |
Worked examples
Worked example: Opposite pushes
The government cuts taxes while the central bank sells bonds. What happens to real GDP and to the interest rate?
- Tax cut: AD right, interest rate up. Bond sales: AD left, interest rate up.
- Real GDP: pushed both ways, so indeterminate. Interest rate: both push up, so it rises.
Answer: GDP indeterminate; interest rate rises
Worked example: Combining sizes
A recessionary gap is \$100 billion and the MPC is 0.8. Government purchases rise by \$10 billion. With prices about unchanged, how much more must monetary policy shift AD?
- Fiscal: $5 \times 10 = 50$ billion.
- Remaining: $100 - 50 = 50$ billion, which monetary policy must add.
Answer: \$50 billion
Common mistake
Giving a definite answer when two policies push a variable in opposite directions. Then the result depends on their sizes. Check: write an arrow for each policy's effect on the variable; if the arrows disagree, the answer is "indeterminate" unless sizes are given.