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Lesson M15.L05: The Policy Mix: Fiscal and Monetary Coordination

Module: The IS-LM Model Part II Level: intermediate Duration: 30 minutes Learning Objective: Evaluate how the fiscal-monetary policy mix determines the composition of aggregate demand. Data as of: 2024 Provenance: Reserve Bank of Australia | OpenStax Macroeconomics 3e

Explanation

Policymakers have two main instruments to influence macroeconomic outcomes:

  1. Fiscal policy (government): controls G (spending) and T (taxes), which shift the IS curve.
  2. Monetary policy (central bank): controls M or the interest rate target r, which shifts the LM curve.

With two instruments, policymakers can pursue two targets simultaneously โ€” a target level of output Y and a target composition of demand (the split between private investment I and public/consumption spending). This is the Tinbergen Principle: one instrument per target.

Four canonical policy mixes:

Fiscal Monetary Effect on Y Effect on r Composition
Expansionary (โ†‘G) Tight (โ†“M) Ambiguous / moderate Higher r Low investment, more government
Expansionary (โ†‘G) Expansionary (โ†‘M) Strongly higher Y Smaller r rise Balanced expansion
Tight (โ†“G) Expansionary (โ†‘M) Ambiguous / moderate Lower r Investment-friendly, less government
Tight (โ†“G) Tight (โ†“M) Strongly lower Y Higher r Contraction

Key insight: To reach a given Y target while changing the composition of demand, mix the instruments:

  • Want higher investment? โ†’ Loosen monetary (lower r), tighten fiscal (offset Y with lower G).
  • Want to crowd in public services? โ†’ Loosen fiscal, tighten monetary (higher r reduces I, but G rises).

Australia COVID-19 (2020): Both arms were expansionary simultaneously. Fiscal stimulus reached ~15% of GDP; the RBA cut to 0.10%. Result: large positive Y impulse with historically low r, minimal crowding out, and investment supported.

Australia 2022โ€“23: As inflation peaked at 7.8% (Q4 2022), the policy mix reversed: the RBA raised the cash rate 13 times (0.10% โ†’ 4.35% by November 2023) while fiscal consolidation reduced the deficit. Both arms tightened, producing a sharp cooling of aggregate demand and eventual easing of inflation.

Notation: G = government spending; M = nominal money supply; r = interest rate; Y = equilibrium output; I = ฤช โˆ’ b_r ร— r = investment; C = consumption.

Worked Example

Setup:

  • IS curve: Y = A โˆ’ 100r, where A is autonomous spending
  • LM curve: Y = B + 100r, where B depends on M/P
  • Investment: I = 400 โˆ’ 60r
  • Target output: Y = 900

Scenario A โ€” Expansionary fiscal + tight monetary (high-r mix):

Suppose policymakers want Y = 900 but at a high interest rate (e.g., to reduce investment pressure on the current account), achieved by raising G and tightening M/P.

Let A = 1200 (IS shifted right by ฮ”G: IS: Y = 1200 โˆ’ 100r) and B = 500 (tight LM: Y = 500 + 100r).

Equilibrium: 

1200 โˆ’ 100r = 500 + 100r
700 = 200r โ†’ r_A = 3.5%
Y_A = 1200 โˆ’ 100(3.5) = 850...
Adjust A = 1300: 
1300 โˆ’ 100r = 500 + 100r
800 = 200r โ†’ r_A = 4%
Y_A = 1300 โˆ’ 100(4) = 900 โœ“

Investment: I_A = 400 โˆ’ 60(4) = 400 โˆ’ 240 = 160**

Scenario B โ€” Tight fiscal + expansionary monetary (low-r mix):

Same Y = 900 target, but with low r to encourage investment. Reduce G (A = 1000, IS: Y = 1000 โˆ’ 100r) and expand M/P (B = 800, LM: Y = 800 + 100r).

Equilibrium: 

1000 โˆ’ 100r = 800 + 100r
200 = 200r โ†’ r_B = 1%
Y_B = 1000 โˆ’ 100(1) = 900 โœ“

Investment: I_B = 400 โˆ’ 60(1) = 400 โˆ’ 60 = 340**

Comparison:

Scenario Y r (%) Investment I
A: Loose fiscal + tight monetary 900 4.0 160
B: Tight fiscal + loose monetary 900 1.0 340

Both achieve the same output level (Y = 900), but the composition is radically different. Scenario B delivers more than double the private investment (340 vs 160) โ€” investment-led growth โ€” while Scenario A delivers government-led growth with suppressed private investment.

Common Misconception

Misconception: Fiscal and monetary policy always work in the same direction โ€” if one is expansionary, the other must also be expansionary to maintain output.

Correction: Fiscal and monetary policy are independent instruments that can be combined in any configuration. The classic Mundell (1962) insight is that the mix determines the composition of output, not just its level. A government wishing to raise output while keeping interest rates low (to avoid exchange-rate appreciation in an open economy, or to encourage capital formation) can loosen monetary policy while keeping fiscal policy neutral. Conversely, a tight fiscalโ€“loose monetary mix (Scenario B above) produces the same Y with a very different investment-consumption composition.

Practice Prompts

  1. Conceptual: Using the IS-LM diagram, illustrate how a simultaneous rightward shift in both IS and LM results in higher output Y with an ambiguous effect on r. What determines whether r rises or falls? โ†’ Answer: IS shifts right (from โ†‘G) and LM shifts right (from โ†‘M). Both push Y up. The interest rate effect depends on the relative magnitudes of the shifts: if LM shifts more than IS, r falls; if IS shifts more, r rises; if they shift equally, r is unchanged. In Australia's COVID response, the aggressive monetary expansion (LM shift) relative to the fiscal shift kept r near zero.

  2. Numerical: Using the model above, find the equilibrium (Y, r) when both instruments are moderately expansionary: A = 1100 (IS: Y = 1100 โˆ’ 100r) and B = 700 (LM: Y = 700 + 100r). What is investment at this equilibrium? โ†’ Answer: 

    IS = LM: 1100 โˆ’ 100r = 700 + 100r
400 = 200r โ†’ r = 2%
Y = 1100 โˆ’ 100(2) = 900
I = 400 โˆ’ 60(2) = 400 โˆ’ 120 = 280
    Y = 900, r = 2%, I = 280. The same output as Scenarios A and B, but with an intermediate interest rate and investment level โ€” confirming the policy mix determines composition, not just the level of Y.

  3. Application: In 2022โ€“23, the RBA raised rates 13 times while the federal government moved toward fiscal surplus. Using the IS-LM framework, trace the effects of this combined tightening on (i) equilibrium output, (ii) the interest rate, and (iii) private investment. โ†’ Answer: (i) Fiscal consolidation (โ†“G) shifts IS leftward, reducing Y at any given r. Monetary tightening (โ†“M or โ†‘r target) shifts LM leftward, raising r and reducing Y further. Combined, both shifts reduce equilibrium Y substantially โ€” consistent with Australian GDP growth slowing from ~3.5% in 2022 to ~1.5% in 2023. (ii) r rises strongly from the monetary tightening (the LM effect dominates). (iii) Higher r reduces private investment via I = ฤช โˆ’ b_r ร— r โ€” consistent with a sharp fall in dwelling investment and business investment in 2023.

Further Resources