Question

Is it also true that sometimes, the right policy mix is instead to use the policies in opposite directions, for example, combining a fiscal consolidation with a monetary expansion? Explain in detail with an example (combining a fiscal consolidation with a monetary expansion) and graphical illustration.

Answer 1

Assume that the government is in its long run equilibrium level initially. This policy mix can be used when the government is suffering from a fiscal or budgetary deficit and it requires a fiscal contraction. At the same time, there is a fear that with government's fiscal consolidation, the economy might not enter a recession. In such a case monetary expansion is used.

With fiscal contraction, there is an increase in taxes or a reduction in government spending, both tend to reduce aggregate spending and shift AD to the left. The economy is now facing a recessionary gap and price level and real GDP are below their full employment level.

To correct this gap, money supply is increased via open market purchased of securities by the central bank. This increases aggregate spending and shift AD to the right. The recessionary gap is eliminated and price level and real GDP return to their full employment levels