The use of expansionary monetary policy affects the LM curve and shifts it to the right. Expansionary fiscal policy on the other hand, shifts the S curve to the right. When the government uses a coordinated use of both monetary and fiscal policy, shifts occur in both the LM curve a well as the IS curve.
In order to achieve full employment in the economy, assume that government adopts an expansionary mix of monetary and fiscal policies. This has been illustrated in the figure below:
As shown in the figure, the economy is in equilibrium at point A where IS1 curve intersects with LM1 curve. At this point, the rate of interest is Or2 and income level is OY1. When the government adopted an expansionary fiscal policy in the form of increased government expenditures (G↑) or decreased taxes (T↓), IS Curve shifts from IS1 to IS2. If an expansionary monetary policy is adopted simultaneously, the interest rate further increases to Or3.
So, in order to encourage investment made by business firms and reduce the interest rate to achieve full employment, the central monetary authority increases the supply of money through open market purchase of securities. This causes the Lm curve to shift rightwards from LM1 to LM2.
The fiscal policy has led to the New IS curve, that is IS2, and the monetary policy has led to a new LM curve, LM2. The intersection point of the curve IS2 and LM2 is the new equilibrium point B, where the interest rate has fallen to Or1 and the income level has risen to OY2. Thus, the expansionary fiscal policy followed by expansionary monetary policy assist one another to maintain an equilibrium level of income/output in the economy.
Assuming that the economy is at full employment level of income, the following diagram illustrates the economic situation at full employment and further shows how fiscal-monetary mix policies affect the equilibrium level of income/output.
In the figure, income level at full employment is OYF. Initially, at OYF level of income, the IS curve intersects LM curve at point E. When the economy faces a downturn due to the occurrence of unfavorable events, more investment should be injected into the economy. For this, the monetary authority increases the supply of money which shifts the LM curve rightwards to LM1. The curve LM1 then intersects with the IS curve to form a new equilibrium point at E1 where, interest rate is lower at Or1, and the increased level of income is OY1.
However, the increase in the level of national income being greater than the existing level of employment level, leads to inflation. So, the economy must change its fiscal-monetary policies mix.
For this, the expansionary monetary policy is combined with a contractionary fiscal policy. Subsequently, the government reduces its expenditures (G↓), and increases taxes (T↑) which shifts the IS curve to IS1. Now, LM curve intersects IS1 at point E2, which is the new equilibrium point. At this point, the interest rate is reduced to Or2 whereas, the income level at full employment is OYF.
Thus, the level of equilibrium is maintained at lower interest rates through the monetary-fiscal policy mix as the reduced rate of interest would increase the level of investment in the economy, and the decrease in government expenditure and increase in tax would maintain a control over inflation.