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on which has a similar effect government spending or tax cuts do not have to make up for the entire output gap there is a multiplier effect that affects the impact of government spending for instance when the government pays for a bridge the project not only adds the bridge s value to output but also enables bridge workers to increase their consumption and investment helping close the output gap the effects of fiscal policy can be limited by partial or full crowding out when the government undertakes spending projects it limits the resources available to the private sector full crowding out occurs in the extreme case when government spending replaces private sector output rather than adding to the economy s output a crowding out effect may also occur if government spending raises interest rates thereby limiting investment 62 some fiscal policy is implemented through automatic stabilizers without any active decisions by politicians automatic stabilizers do not suffer from the policy lags of discretionary fiscal policy automatic stabilizers use conventional fiscal mechanisms but take effect as soon as the economy takes a downturn spending on unemployment benefits automatically increases when unemployment rises and tax revenue decreases which shelters private income and consumption from part of the fall in market income 10 657 comparison of fiscal and monetary policy edit there is a consensus that both monetary and fiscal instruments may affect demand and activity in the short run i e over the business cycle 10 657 economists usually favor monetary over fiscal policy to mitigate moderate fluctuations however because it has two major advantages citation needed first monetary policy is generally implemented by independent central banks instead of the political institutions that control fiscal policy independent central banks are less likely to be subject to political pressure to pursue overly expansionary policies second monetary policy may suffer shorter inside lags and outside lags than fiscal policy 53 there are some exceptions however firstly in the case of a major shock monetary stabilization policy may not be sufficient and should be supplemented by active fiscal stabilization 10 659 secondly in the case of a very low interest level the economy may be in a liquidity trap in which monetary policy becomes ineffective which makes fiscal policy the more potent tool to stabilize the economy 8 thirdly in regimes where monetary policy is tied to fulfilling other targets in particular fixed exchange rate regimes the central bank cannot simultaneously adjust its interest rates to mitigate domestic business cycle fluctuations making fiscal policy the only usable tool for such countries 57 macroeconomic models edit further information macroeconomic model macroeconomic teaching research and informed debates normally evolve around formal diagrammatic or equational macroeconomic models to clarify assumptions and show their consequences precisely models include simple theoretical models often containing only a few equations used in teaching and research to highlight key basic principles and larger applied quantitative models used by e g governments central banks think tanks and international organisations to predict effects of changes in economic policy or other exogenous factors or as a basis for making economic forecasting 63 well known specific theoretical models include short term models like the keynesian cross the is lm model and the mundell fleming model medium term models like the ad as model building upon a phillips curve and long term growth models like the solow swan model the ramsey cass koopmans model and peter diamond s overlapping generations model quantitative models include early large scale macroeconometric model the new classical real business cycle models microfounded computable general equilibrium cge models used for medium term structural questions like international trade or tax reforms dynamic stochastic general equilibrium dsge models used to analyze business cycles not least in many central banks or integrated assessment models like dice specific models edit is lm model edit in this example of a traditional is lm chart the is curve moves to the right causing higher interest rates i and expansion in the real economy real gdp or y the is lm model invented by john hicks in 1936 gives the underpinnings of aggregate demand itself discussed below it answers the question at any given price level what is the quantity of goods demanded the graphic model shows combinations of interest rates and output that ensure equilibrium in both the goods and money markets under the model s assumptions 64 the goods market is modeled as giving equality between investment and public and private saving is and the money market is modeled as giving equilibrium between the money supply and liquidity preference equivalent to money demand 65 the is curve consists of the points combinations of income and interest rate at which for a given interest rate investment equals public and private saving given output 66 the is curve is downward sloping because output and the interest rate have an inverse relationship in the goods market as output increases more income is saved which means interest rates must be lower to spur enough investment to match saving 66 the traditional lm curve is upward sloping because the interest rate and output are positively related in the money market as income identical to output in a closed economy increases the demand for money rises leading to a higher interest rate to offset the incipient rise in money demand 67 the is lm model is often used in elementary textbooks to demonstrate the effects of monetary and fiscal policy though it ignores many complexities of most modern macroeconomic models 64 a problem related to the lm curve is that modern central banks largely ignore the money supply in determining policy contrary to the model s basic assumptions 9 262 in some modern textbooks consequently the traditional is lm model has been modified by replacing the traditional lm curve with an assumption that the central bank determines the interest rate of the economy directly 9 194 8 113 ad as model edit a traditional ad as diagram showing a shift in ad and the as curve becoming inelastic beyond potential output the ad as model is a common textbook model for explaining the macroeconomy 68 the original version of the model shows the price level and level of real output given the equilibrium in aggregate demand and aggregate supply the aggregate demand curve s downward slope means that more output is demanded at lower price levels 69 the downward slope can be explained as the result of three effects the pigou or real balance effect which states that as real prices fall real wealth increases resulting in higher consumer demand of goods the keynes or interest rate effect which states that as prices fall the demand for money decreases causing interest rates to decline and borrowing for investment and consumption to increase and the net export effect which states that as prices rise domestic goods become comparatively more expensive to foreign consumers leading to a decline in exports 69 in many representations of the ad as model the aggregate supply curve is horizontal at low levels of output it becomes inelastic near the point of potential output which corresponds with full employment 68 since the economy cannot produce beyond the potential output any ad expansion will lead to higher price levels instead of higher output in modern textbooks the ad as model is often presented slightly differently however in a diagram showing not the price level but the inflation rate along the vertical axis 9 263 14 399 428 10 595 making it easier to relate the diagram to real world policy discussions 10 vii in this framework the ad curve is downward sloping because higher inflation will cause the central bank which is assumed to follow an inflation target to raise the interest rate which will dampen economic activity hence reducing output the as curve is upward sloping consistent with a standard modern phillips curve view in which higher economic activity lowers unemployment leading to higher wage growth and in turn higher inflation 9 263 see also edit business and economics portal microeconomics business cycle accounting economic development growth accounting references edit samuelson robert 2020 goodbye readers and good luck you ll need it the washington post this article was an opinion piece expressing despondency in the field shortly before his retirement but it is still a good summary what is macroeconomics board of governors of the federal reserve system retrieved 2025 12 08 o sullivan arthur sheffrin steven m 2003 economics principles in action upper saddle river new jersey pearson prentice hall p 57 isbn 978 0 13 063085 8 steve williamson notes on macroeconomic theory 1999 1 2 3 micro and macro the economic divide imf 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