Monetary and fiscal policy - Essay Example

[1] Fiscal policy is the attempt to influence the level of economic activity through changing taxation and government spending. The fiscal policy helps in fixing aggregate demand through government spending and thus decides the level of economic activity in the country. IS or Investment Saving is a graph showing the balance between investment and savings. When plotted with income on the X axis and interest rate on the Y axis, the graph has a negative slope ie as the income increases, the supply of loanable funds goes down.

This is to prevent an imbalance in the economy. The IS/LM model is a macroeconomic tool that demonstrates the relationship between interest rates and real output in the goods and services market and the money market. The intersection of the IS and LM curves is the "General Equilibrium" where there is simultaneous equilibrium in all the markets of the economy[2] There is a classical correlation between the monetary and fiscal policies and IS/LM. When there is a probability of inflation, which is rare in U.

K as it has already been set at 2% by the government, the interest rates are increased by the government through the monetary policy. If the interest rates are high, demand slows down and the growth rate of the economy is arrested. If there are chances of a rapid inflation, the government can hike up the taxes that will in turn reduce spending. As a result, aggregate demand will be reduced and inflation will be controlled. Similarly, if there is a threat of recession, the government can reduce taxes and increase government spending.

Lower taxes would translate in higher disposable incomes and thus, aggregate demand would increase. An increased demand would combat the recession and bring the economy back on its course. In other words, IS-LM can be said to show the relation between the theory of effective demand and the theory of liquidity preference. If we assume that there are only two