Linking the Keynesian Cross and the IS-LM Models: Fiscal Policy and Monetary Policy

 

 

 

I           Fiscal policy in the K Cross model involves raising or lowering aggregate expenditure.

            Raise AE to combat recession (raise equilibrium GDP), lower AE to combat inflation.

Whether, in boosting the economy, the prescription is to raise government spending or to lower taxes, the effect will be similar. 

            In restraining the economy,  to combat inflation,  a similar point applies.

 

II          Monetary policy in the K Cross involves raising or lowering aggregate expenditure through another means. 

An increase in the money supply lowers interest rates and  stimulates investment spending.  A decrease in the money supply does the opposite.

 

III        In the IS-LM model, stimulative fiscal policy actions by the government shift the IS curve to the right.  This means that at any interest rate there is more spending than before.

            Given no shift in the LM curve, the interest rate rises, and GDP rises.

            Restrictive fiscal policy actions shift the IS curve to the left, etc.

 

IV.       In the IS-LM model, stimulative monetary policy shifts the LM curve to the right.

This increased money supply implies that lower interest rates will be associated with any particular GDP than before (LM shifts right or down)

            In combination with a constant IS curve, the interest rate falls and GDP increases.

            Restrictive monetary policy actions shift the LM curve to the left, etc..