A given fiscal policy means a given path of government spending and tax rates. A given
monetary policy must specify the implicit monetary policy rule by which interest rates are
set. In this chapter, we assume that is to achieve a given money supply target.
The IS schedule shows combinations of interest rates and output compatible with short-run
equilibrium output in the goods market. Lower interest rates boost demand and output.
Other causes of shifts in demand are shown as shifts in the IS schedule.
The LM schedule shows combinations of interest rates and output compatible with money
market equilibrium when the central bank pursues a money supply target. Higher output is
associated with higher interest rates to maintain the equality of money supply and money
demand.
The intersection of IS and LM schedules shows simultaneous equilibrium in both goods and
money markets, jointly determining output and interest rates.
With a given monetary policy, a fiscal expansion increases output, money demand and
interest rates, thus crowding out or partially displacing private consumption and investment
demand.
For a given fiscal policy, a monetary expansion leads to lower interest rates and higher
output.
The mix of monetary and fiscal policy affects the equilibrium interest rate as well as the level
of output.
Ricardian equivalence says that for a given present value of government spending, the
private sector does not care when this is financed by taxes, since the total present value of
taxes is the same. A tax cut today has no effect on aggregate demand since people
anticipate higher future taxes to finance the extra debt interest.
Ricardian equivalence is only true under extreme assumptions and not generally true in
practice. Hence tax cuts today do have some effect today. This effect is damped by the
knowledge that, unless government spending is also cut, future taxes will have to rise.
Demand management helps stabilize output. Fiscal policy may be difficult to adjust quickly,
and may be difficult politically to reverse later: much of its impact on aggregate demand
thus arises through automatic stabilizers with an unchanged fiscal policy.
