Having looked at the market for goods and services and the determination output, and financial markets and the determination of the nominal interest rate, in isolation, we shall now look at the interactions between these two markets. We shall focus on the simultaneous short run determination of fluctuations in output (and implicitly employment) and the interest rate.
We shall, as in the basic keynesian model, assume that in the short-run the price level is predetermined as the adjustment of the prices of goods and services in very gradual.
This assumption, of a fixed price level in the short run, , because of slow price adjustment, is the basis of the Keynesian approach to macroeconomics and aggregate fluctuations.
However, unlike the prices of goods and services, which are assumed to adjust slowly, it is assumed that financial prices, such as bond prices and interest rates, adjust immediately so as to equilibrate domestic financial markets.
Short-run equilibrium in a closed economy is determined at the level of output and the interest rate where two conditions are met,
1. The market for goods and services is in equilibrium, in the sense that aggregate demand equals aggregate supply,
The product market remains in equilibrium through adjustments in output (aggregate supply) to the level of aggregate demand, as determined by consumption, investment, which is now assumed to depend positively on output and negatively on the nominal interest rate, and government purchases. The combinations of output and the interest rate which maintain equilibrium in the product market lie along a negatively sloped curve, the IS curve. The IS curve is negatively sloped because an increase in the nominal interest rate causes a fall in investment, a fall in aggregate demand and a concomitant fall in output.
2. The domestic money market is in equilibrium, in the sense that the demand for money equals the supply of money by the central bank.
When the central bank controls the money supply, the money market remains in equilibrium through adjustments in the nominal interest rate. The combinations of output and the interest rate which maintain equilibrium in the money market lie along a positively sloped curve, the LM curve. The LM curve is positively sloped because, for a given money supply, an increase in output, which increases the demand for money, must be accompanied by an increase in the nominal interest rate, which reduces the demand for money, for the money market to remain in equilibrium. When the central bank pegs nominal interest rates, the money market remains in equilibrium through endogenous adjustments in the money supply, and the LM curve is horizontal, at the nominal interest rate decided by the central bank.
When the central bank controls the money supply, a fiscal expansion (increase in government purchases or reduction in taxes) causes a short run increase of both the nominal interest rate and real output.
A monetary expansion (increase in the money supply) results in a short run reduction of the nominal interest rate and an increase in real output.
We have looked so far at fiscal policy and monetary policy in isolation. Our purpose was to show how each worked. In practice, the two are often used together. The combination of monetary and fiscal policies is known as the monetary–fiscal policy mix, or simply the policy mix.
The policy mix can be either a expansionary monetary and fiscal policy, or an expansionary monetary policy and a contractionary fiscal policy, or a contractionary monetary policy and an expansionary fiscal policy, or a contractionary monetary and fiscal policy.
If the central bank pegs the nominal interest rate, a fiscal expansion (increase in government purchases or reduction in taxes) causes a larger short run increase of real output, as the money supply also expands in order to maintain the nominal interest rate constant. Thus, under interest rate pegging, a fiscal expansion ends up as a combination of a fiscal and a monetary expansion.
Sometimes, the right mix is to use fiscal and monetary policy in the same direction. This was the case for example during the recessions of 2001 and 2007-09 in the United States, where both an expansionary monetary and an expansionary fiscal policy were used to fight the recession.
Sometimes, the right mix is to use the two policies in opposite directions, for example, combining a fiscal contraction with a monetary expansion. This was the case in the early 1990s in the United States. When Bill Clinton was elected President in 1992, one of his priorities was to reduce the budget deficit, using a combination of cuts in spending and increases in taxes. Clinton was worried, however, that, by itself, such a fiscal contraction would lead to a decrease in demand and trigger another recession. The strategy chosen was to combine a fiscal contraction (so as to get rid of the deficit) with a monetary expansion (to make sure that demand and output remained high). This was carried out by Bill Clinton (who was in charge of fiscal policy) and Fed Chairman Alan Greenspan (who was in charge of monetary policy). The result of this strategy—and a bit of economic luck—was a steady reduction of the budget deficit (which turned into a budget surplus at the end of the 1990s) and a steady increase in output throughout the rest of the decade.
The current policy mix in the USA seems to be a neutral monetary policy, as the Fed has indicated that it will not continue to raise interest rates, and an expansionary fiscal policy, as President Trump has enacted a tax cut and intends to increase government spending for infrastructure investment.
Blanchard Ch. 5
Macroeconomics 