Monetary policy adopted by the government affects the LM curve, whereas, the fiscal policy affects the IS curve. Expansionary monetary policy shifts the LM curve to the right, lowers interest rates and stimulates aggregate output. Contractionary monetary policy has an inverse effect on the curve.
On the other hand, Fiscal policy causes a shift in the IS curve, where an expansionary policy shifts the curve to the right, stimulates aggregate demand by increasing government expenditures and reducing tax rates.
The effect of the changes in the policies on interest rates and aggregate income/output has been discussed further.
Response to a Change in Monetary Policy
The figure presented below illustrates the changes that occur in interest rates and output as a result of increased money supply in the economy.
Initially, the economy was in equilibrium at point E for both money market and goods market, where the IS curve IS1 intersects the LM curve LM1. Assuming that, at Y1 level of aggregate output, the economy is suffering from an unemployment rate of 10%, so, as a part of its expansionary monetary policy, the government decides to reduce unemployment and increase output by raising the supply of money.
The rise in money supply results in the rightward supply of LM curve, from LM1 to LM2 which moves the equilibrium point of the goods market and money market to E1 (intersection of IS1 and LM2). As a result of increased money supply, interest rates decline from i1 to i2, and aggregate level of output increased from Y1 to Y2.
When the equilibrium is at point E1, the rise in money supply (shifts the LM curve to the right) creates excess of money supply, and decreases the interest rate. Subsequently, investment expenditures and net export rise, which leads to an increase in the aggregate demand and consequently, aggregate output rises. When the economy reaches at E2, the excess supply of money is eliminated because the fall in interest rates and increase in aggregate output have raised the demand for quantity demanded for money. This keeps increasing until it equals the increased supply of money.
Contrarily, a decline in the supply of money has a reverse effect. It shifts the LM curve to the left, resulting in reduced output and increased interest rates. Thus, a positive relationship can be determined between aggregate output and money supply. Aggregate output expands with the increase in money supply and contracts as money supply decreases.
Response to a Change in Fiscal Policy
The ISLM model can demonstrate how changes in fiscal policy affects interest rates and aggregate output. When the government is not willing to raise the supply of money when the economy is suffering from unemployment at E1 point of equilibrium, the federal government adopts an expansionary fiscal policy.
The figure shows how interest rates and aggregate output respond to the fiscal policy where the government has increased its expenses and reduced taxes on disposable income.
An increase in spending made by the government or the reduction in taxes cause the IS curve to shift from IS1 to IS2. The equilibrium point in both the goods market and money market shift from E1 to E2, where the IS curve, IS2 and LM curve, 1 intersect. The change in fiscal policy results in rise in aggregate output from Y1 to Y2, and a rise in rate of interest from i1 to i2.
The change in fiscal policy leads to an increased level of output and interest rates is because an increase in government expenses directly affects aggregate demand. A decline in taxes result in more disposable income, consequently leading to a rise in consumption expenditure. The rise in aggregate demand raises the aggregate output, which subsequently leads to increase in demand for money. This further creates an excess demand of money, which in turn increases the rate of interest.
At equilibrium point E2, the excess of money demand in the economy due to rise in aggregate output is eliminated by the increment in interest rates, which lowers the demand for money.
A contractionary fiscal policy on the other hand, has a reverse effect, and so it reduces aggregate demand, shifts the IS curve to the left and causes in the decline of interest rates and final output. Thus, it can be concluded that aggregate output and interest rates have a positive relationship with government expenses, whereas they have a negative relationship with taxes.
