Monetary policy affects the economy, first, by affecting the interest rate and then by
affecting aggregate demand. An increase in the money supply reduces the interest
rate, increases investment spending and aggregate demand, and thus increases equilibrium
output.
There are two extreme cases in the operation of monetary policy. In the classical
case the demand for real balances is independent of the rate of interest. In that case
monetary policy is highly effective. The other extreme is the liquidity trap, the case
in which the public is willing to hold any amount of real balances at the going interest
rate. In that case changes in the supply of real balances have no impact on interest
rates and therefore do not affect aggregate demand and output.
Taking into account the effects of fiscal policy on the interest rate modifies the
multiplier results of Chapter 9. Fiscal expansion, except in extreme circumstances,
still leads to an income expansion. However, the rise in interest rates that comes
about through the increase in money demand caused by higher income dampens
the expansion.
Fiscal policy is more effective the smaller the induced changes in interest rates and
the smaller the response of investment to these interest rate changes.
The two extreme cases, the liquidity trap and the classical case, are useful to show
what determines the magnitude of monetary and fiscal policy multipliers. In the liquidity
trap, monetary policy has no effect on the economy, whereas fiscal policy
has its full multiplier effect on output and no effect on interest rates. In the classical
case, changes in the money stock change income, but fiscal policy has no effect on
income—it affects only the interest rate. In this case, there is complete crowding out
of private spending by government spending.
A fiscal expansion, because it leads to higher interest rates, displaces, or crowds out,
some private investment. The extent of crowding out is a sensitive issue in assessing
the usefulness and desirability of fiscal policy as a tool of stabilization policy.
The question of the monetary-fiscal policy mix arises because expansionary monetary
policy reduces the interest rate while expansionary fiscal policy increases the
interest rate. Accordingly, expansionary fiscal policy increases output while reducing
the level of investment; expansionary monetary policy increases output and the
level of investment.
Governments have to choose the mix in accordance with their objectives for economic
growth, or increasing consumption, or from the viewpoint of their beliefs
about the desirable size of the government.
