Congress controls fiscal policy (government spending and taxes). The Federal Reserve controls monetary policy (the money supply and interest rates). Both can shift aggregate demand. Set each policy below and watch what happens to real GDP, the price level, and the interest rate when they work together or against each other.
Pick where the economy starts, then set fiscal and monetary policy. Dashed grey lines show the curves before any policy action.
Changes in government spending (G) and taxes (T), set by Congress and the President. Expansionary fiscal policy raises G or cuts T to shift AD right. Contractionary does the reverse.
Expansionary: buy bonds, lower the discount rate, lower the reserve requirement, lower interest on reserves. Contractionary: the opposite of each. Open market operations are the tool AP questions use most.
Fed buys bonds → money supply rises → interest rate falls → investment and interest-sensitive consumption rise → AD shifts right.
Higher spending raises income, so people want to hold more money for transactions. Money demand shifts right, and the nominal interest rate rises. Government borrowing pushes the same way.
Spending multiplier = 1 / MPS. Tax multiplier = −MPC / MPS. A tax cut has a smaller effect than the same increase in G, because people save part of a tax cut before spending any of it.
If one policy pushes AD right and the other pushes it left, you cannot tell what happens to real GDP and the price level without knowing which is bigger. On the exam, the answer is "indeterminate."
Each cell shows the short-run effect on real GDP and the price level (Y, P) and on the nominal interest rate (i). A ? means the effect is indeterminate.
| Fiscal ↓ / Monetary → | Expansionary (buy bonds) | No change | Contractionary (sell bonds) |
|---|---|---|---|
| Expansionary (G↑ or T↓) | Y↑ P↑ · i ? | Y↑ P↑ · i↑ | Y ? P ? · i↑ |
| No change | Y↑ P↑ · i↓ | No change | Y↓ P↓ · i↑ |
| Contractionary (G↓ or T↑) | Y ? P ? · i↓ | Y↓ P↓ · i↓ | Y↓ P↓ · i ? |
Notice the pattern. When both policies point the same way, the AD effect is certain and the interest rate is the question mark. When they point opposite ways, the interest rate is certain and the AD effect is the question mark.
FRQs often ask for the minimum change in government spending or taxes needed to close a gap. Enter the gap and the MPC.
AP-style multiple choice. Pick an answer to see the explanation.
The vocabulary for topic 5.1. Read the list, flip through flashcards, or quiz yourself. For every term in the unit, see the Unit 5 terminology guide.