Topic 5.1 Notes – Fiscal and Monetary Policy Actions in the Short Run

1. Fiscal and Monetary Policy in the Short Run

In the AD-AS model, long-run equilibrium happens where AD, SRAS, and LRAS intersect at potential GDP.

When the economy moves away from that point, we get an output gap:

• Recessionary (negative) output gap → actual GDP < potential GDP
• Inflationary (positive) output gap → actual GDP > potential GDP

In the short run, policymakers mainly shift aggregate demand (AD).

Two types of policy:

• Fiscal policy
  • Done by Congress and the President
  • Changes government spending (G) and/or taxes (T)
  • Directly affects components of AD
• Monetary policy
  • Done by the Federal Reserve
  • Changes money supply and interest rates
  • Affects investment and consumption, which shifts AD

Both influence:

• Real GDP
• Unemployment
• Price level
• Interest rates (especially with monetary policy)

2. The Two Output Gaps Policymakers Are Trying to Fix

Recessionary Gap

Here, output is below potential and unemployment is above the natural rate.

Recessionary gap in the AD-AS model

In the graph, equilibrium output (Q) is to the left of potential output (Q′) at LRAS. That distance between Q and Q′ is the recessionary gap.

To fix it, policymakers use expansionary policy, which shifts AD right.

Effects in the short run:

• Real GDP ↑
• Unemployment ↓
• Price level ↑ (usually mild inflation)

Historical anchors:

• Great Depression and the New Deal under FDR used expansionary fiscal policy.
• 2008 financial crisis and COVID-19 stimulus (2020-21) involved expansionary fiscal policy.
• The Fed cut rates aggressively in both periods.

Inflationary Gap

Here, output is above potential and unemployment is below the natural rate. Inflation pressures build.

In an inflationary gap, AD has shifted right past LRAS, so actual output exceeds potential output. That distance between actual GDP and potential GDP is the inflationary gap.

To fix it, policymakers use contractionary policy, which shifts AD left.

Effects in the short run:

• Real GDP ↓
• Inflation ↓
• Unemployment ↑

Historical anchor:

• Paul Volcker (early 1980s) used contractionary monetary policy to fight high inflation.

3. Fiscal and Monetary Policy Tools and Their Direction

Both types of policy can be expansionary or contractionary.

Fiscal Policy

Mechanism:

• ↑ G directly raises AD
• ↓ T increases disposable income → C rises → AD rises

Monetary Policy

The Fed’s main tools:

• Open market operations (buy/sell bonds)
• Discount rate
• Reserve requirement

Expansionary monetary policy:

• Buy bonds
• Lower discount rate
• Lower reserve requirement
• → Money supply ↑
• → Interest rates ↓
• → Investment (I) and consumption (C) ↑
• → AD shifts right

Contractionary monetary policy:

• Sell bonds
• Raise discount rate
• Raise reserve requirement
• → Money supply ↓
• → Interest rates ↑
• → I and C ↓
• → AD shifts left

Know this chain clearly: Money supply → interest rates → investment/consumption → AD

On graph questions, they often expect you to explain that full transmission story, not just “AD shifts.”

4. How Combined Policies Work Together

Policymakers often act at the same time.

Fixing a Recession

1. Expansionary fiscal policy shifts AD right.
2. Expansionary monetary policy lowers interest rates.
3. Lower rates increase I and C even more.
4. AD shifts further right.

Result:

• Real GDP rises toward potential
• Unemployment falls
• Price level increases

The 2008 response is a good example. Congress passed stimulus, and the Fed lowered rates and bought bonds.

Fixing Inflation

1. Contractionary fiscal policy shifts AD left.
2. Contractionary monetary policy raises interest rates.
3. Higher rates reduce I and C.
4. AD shifts further left.

Result:

• Inflation falls
• GDP decreases in the short run
• Unemployment rises

That’s what happened during the Volcker disinflation.

If fiscal is expansionary while monetary is contractionary, they partially cancel each other. The AP sometimes tests this conflict.

5. Graphing and Explaining on Tests

When you see a prompt:

• Identify the gap.
• Shift AD in the correct direction.
• Show new short-run equilibrium.
• State effects on:
  • Real GDP
  • Price level
  • Unemployment
  • Interest rates (if monetary policy is involved)

Be precise. “Lower interest rates increase investment spending, which increases aggregate demand” earns more points than just “AD increases.”