5.1 Fiscal and Monetary Policy Actions in the Short Run

Fiscal Policy Tools

Expansionary fiscal policy (increased government spending, tax cuts) shifts AD right to fight recession, closing negative output gaps. Contractionary fiscal policy (decreased spending, tax hikes) shifts AD left to fight inflation, closing positive output gaps. These actions target real GDP, unemployment, and price level in the short run.

Monetary Policy Tools

The Fed uses open market operations, the discount rate, and reserve requirements to adjust the money supply. Expansionary monetary policy increases money supply, lowering interest rates, boosting investment/consumption, shifting AD right. Contractionary monetary policy decreases money supply, raising rates, shifting AD left to curb inflation.

Short-Run Effects on the Economy

Both policies shift AD, moving the economy along the short-run aggregate supply (SRAS) curve, changing real GDP and price level together. Effective policy closes output gaps: expansionary policy raises GDP toward potential during recessions, while contractionary policy lowers GDP/inflation during overheating, though effects involve time lags.

Key terms

Expansionary fiscal policy

Increased government spending and/or tax cuts to shift AD right and close a negative output gap.

Contractionary fiscal policy

Decreased government spending and/or tax increases to shift AD left and close a positive output gap.

Open market operations

The Fed buying or selling government securities to change the money supply and interest rates.

Discount rate

The interest rate the Fed charges commercial banks for short-term loans; lowering it is expansionary.

Reserve requirement

The minimum fraction of deposits banks must hold; lowering it increases the money supply (expansionary).

Try an AP-style question

Which policy combination most clearly increases real GDP?

1. Spending cut and bond sale
2. Tax cut and Fed bond purchase
3. Tax hike and bond purchase
4. Tax cut and Fed bond sale