Keynesian theory holds that aggregate demand drives output and employment. If aggregate demand increases, output will also rise as long as there is excess production capacity. Monetary and fiscal policy can be used to boost aggregate demand and increase output towards full employment. However, fiscal policy expansion may be partly offset or "crowded out" if it raises interest rates and reduces private investment. The effectiveness of fiscal and monetary policy mixes depends on the slopes of the IS and LM curves.

1. Keynesian theory of Income and
employment

7. • Therefore if aggregate demand increases,
output will increase, prices remaining the
same. And due to the existence of excess
production capacity and unemployed
resources (especially manpower) the economy
will reach the point of full employment

45. Monetary and Fiscal
Policy

66. Crowding Out

72. 11-72
Fiscal Policy and Crowding Out
• If the economy is initially in
equilibrium at E, if
government expenditures
increases, equilibrium moves
to E”
• The goods market is in
equilibrium at E”, but the
money market is not
• Y has increased  demand
for money also increases 
interest rate increases
• Firms’ planned investment
spending declines at higher
interest rates and AD falls off
 move up the LM curve to
E’
[Insert Figure 11-4 here]

73. 11-73
Fiscal Policy and Crowding Out
• Increased government
spending increases income
and the interest rate
• Higher interest rates and their
impact on AD dampen the
expansionary effect of
increased G
• Income increases to Y’0
instead of Y”
[Insert Figure 11-4 here]
Increase in government expenditures
crowds out investment spending.

74. 11-74
Fiscal Policy and Crowding Out
• Flat LM curve:
 large effect on output, small
change in interest rate
• Flat IS curve:
 little effect on output or
interest rate
• The larger the multiplier, the
further the IS curve shifts
• if economy at full employment,
higher G raises P  real money
supply falls  interest rate goes
up  I falls
[Insert Figure 11-4 here]

75. 11-75
The Composition of Output
and the Policy Mix
• Monetary policy operates by stimulating interest-responsive components of
AD
• Fiscal policy operates through G and t  impact depends upon what goods the
government buys and what taxes and transfers it changes
– Increase in G  increases C along with G; reduction in income taxes increases C
• Accommodating monetary policy: fiscal expansion accompanied by monetary
expansion: both curves shift, output increases, interest rate stays the same
[Insert Table 11-2 here]

76. 11-76
The Composition of Output
and the Policy Mix
• Figure shows the policy problem of
reaching full employment output,
Y*, for an economy that is initially at
point E, with unemployment
• Should a policy maker choose:
 Fiscal policy expansion, moving
to E1, with higher income and
higher interest rates
 Monetary policy expansion,
resulting in full employment
with lower interest rates at E2
 Mix of fiscal expansion and
accommodating monetary
policy resulting in an
intermediate position
[Insert Figure 11-8 here]