12 Monetary and Fiscal Policy

Lecture from: 02.12.2025 | Video: Video ETHZ

Policy-Making with the AD-AS Model

The AD-AS framework is now applied to understanding how policymakers influence short-run economic fluctuations.

Recap of the Model:

• AD Curve: Downward sloping.
• SRAS Curve: Upward sloping.
• LRAS Curve: Vertical (Potential Output).

Analysis Process:

1. Identify Shock (AD or AS).
2. Determine Shift Direction.
3. Find Short-Run Equilibrium.
4. Analyze Transition (Self-Correction via $P^e$ adjustment).

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Case Study: Analyzing a Recession (Negative Demand Shock)

Scenario: A decrease in exports (e.g., due to foreign tariffs) reduces aggregate demand.

1. Shock: Demand falls. AD shifts Left ($A{D}_1\to A{D}_2$).
2. Short-Run Equilibrium: Economy moves from Point A to Point B.
   • Result: Output falls ($Y_2<Y_1$) and Price Level falls ($P_2<P_1$).

Two Paths Forward

At Point B (Recession), policymakers face a choice.

Path 1: Passive Approach (Self-Correction)

• Logic: The recession puts downward pressure on wages and prices.
• Mechanism: People lower their price expectations ($P^e\downarrow$). This shifts SRAS to the Right.
• Outcome: Economy moves to Point C. Output returns to potential ($Y_1$), but at a permanently lower price level ($P_3$).
• Pros/Cons: Restores specific full employment naturally, but requires waiting through a painful recession.

Path 2: Active Stabilization Policy

• Logic: Use policy tools to boost demand immediately.
• Mechanism: Expansionary Fiscal or Monetary policy shifts AD back to the Right.
• Outcome: Economy moves back to Point A.
• Pros/Cons: Avoids the recession, but risks overshooting or creating inflation if timed poorly.

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Policy Tools for Stabilization

1. Fiscal Policy

Controlled by the Government. Tools:

• Government Spending ($G$): Direct purchase of goods (e.g., infrastructure). Shifts AD directly.
• Taxes ($T$): Indirect effect. Tax cuts increase Disposable Income ($Y-T$) $\to$ Consumption ($C$) rises $\to$ AD shifts right.

2. Monetary Policy

Controlled by the Central Bank. Tool: Money Supply ($M$).

• Mechanism: Increase $M$ $\to$ Interest Rate ($r$) falls $\to$ Investment ($I$) rises $\to$ AD shifts right.

Which tool is better?

It depends on the shock.

• Specific Sector Shock: Fiscal policy can be targeted (e.g., aid for watchmakers).
• General Shock: Monetary policy lifts the entire economy by stimulating investment everywhere.

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The Debate: Active vs. Passive Policy

Should the government try to smooth out the business cycle?

The Case For Active Stabilization

• Keynesian View: “In the long run we are all dead.” The self-correcting mechanism is too slow.
• Argument: Recessions cause unnecessary suffering (unemployment, lost output). Since tools exist to fix them, they should be used.

The Case Against Active Stabilization

• Classical View: Policy can be destabilizing due to lags.
  1. Recognition Lag: Data takes months to gather; identifying a recession is slow.
  2. Implementation Lag: Fiscal policy requires political debate (months/years).
  3. Effect Lag: Monetary policy takes 9-12 months to impact the economy.
• Risk: By the time a stimulus package hits, the economy might already have recovered. Adding stimulus to a recovering economy causes overheating/inflation.

Automatic Stabilizers

To bypass lags, modern economies rely on automatic stabilizers, policies that stimulate AD without new legislation.

• Taxes: When incomes fall, tax bills fall automatically. (Automatic Tax Cut).
• Welfare: When people lose jobs, they collect unemployment insurance. (Automatic Spending Increase).

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Analyzing Supply Shocks

Scenario: An oil price spike raises production costs.

1. Shock: Costs rise. SRAS shifts Left ($A{S}_1\to A{S}_2$).
2. Result: Economy moves to Point B.
   • Output Falls (Stagnation).
   • Prices Rise (Inflation).
   • outcome: Stagflation.

The Policy Dilemma

Supply shocks present a “pick your poison” scenario.

• Option 1: Fight Recession. Expand AD.
  • Result: Output returns to normal, but Inflation explodes.
• Option 2: Fight Inflation. Contract AD.
  • Result: Prices stabilize, but Unemployment skyrockets.

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Review Quiz: Key Concepts

Question 1: Economic Forecasting

Q: Short-run forecasting affects…

A. …only government policy. B. …both government policy and firm planning.

Answer: B. Data is crucial for all agents. Firms use it to plan production; Govts use it to time policy.

Question 2: Real Business Cycle (RBC) Theory

Q: What drives cycles in the RBC model?

Answer: Technology shocks. (Supply-side). RBC models deny sticky prices/wages. A recession is a rational response to lower productivity (e.g., bad harvest), not a demand failure.

Question 3: Liquidity Preference

Q: Keynes’s theory states the interest rate is determined by…

Answer: Supply and Demand for Money. (The opportunity cost of holding liquidity).

Question 4: Money Market Dynamics

Q: If the Price Level ($P$) rises…

Answer: Money Demand shifts Right. (People need more cash to buy the same goods). Interest rate rises.

Question 5: AD Slope Sources

Q: For the Euro Area (large, closed-ish), the main reason for AD’s downward slope is…

Answer: The Interest-Rate Effect. (Wealth effect is small; Exchange-rate effect is small for closed economies).

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Continue here: 13 Phillips Curve & Supply-side Policies