Question

Fiscal policy and monetary policy can both be used to influence aggregate de- mand. Suppose that the aggregate demand curve can be shifted by the same amount by either changing government expenditures by some amount ?G or by changing the nominal money supply by some amount ?M. Consider the variables P, Y, C, I, G and r. In the long-run, on which of these variables do these two policies have an identical effect? On which of these variables do these policies have a different effect? Justify your answers!

Answer 1

In the long-run change in government expenditure and change in the money supply will have an identical effect on consumption (C), price level (P), and income (Y).

This is because both ?G and ?M will cause the aggregate demand to shift. The shift in the aggregate demand (AD) for a given price level will result in the change in income. For instance increase in G or increase in M will both cause the AD curve to shift upward to the right. As a result, for a given price level the income will increase in both the cases and increased income will cause consumption to rise through the multiplier effect. The shift in the AD curve will result in the price level to increase in both the cases. The opposite is true in the case of a decline in G or decline in M.

On the other hand, in the long-run ?G and ?M will have a different effect on investment (I), interest rate (r), and government expenditure (G).

For instance, an increase in the government expenditure will result in higher G, as a result of the increase in the G the income in the economy will rise. For a given level of money supply, the increased income will result in higher level of transaction demand for money, because of which people will start to withdraw money from their speculative balances. To keep the money market in equilibrium, the interest rate (r), will rise. Increase in the interest rate will cause the investment (I) to decline as it will now become expensive for the firms to borrow for the purchase of machinery and equipment. The opposite is true if government expenditure declines.

On the other hand, if the money supply is increased then for a given level of income people will have more money in their hand. This will cause the speculative demand for money to rise. Because of this, the interest rate will decline to keep the money market in equilibrium. The decline in the interest rate will result in increased investment (I), as it will now become cheaper for firms to borrow for the purchase of machinery and equipment. On the whole, there will be no impact on the government expenditure (G). The opposite is true if the money supply is declined.