KEYNESIAN AND MONETARIST VIEWS ON THE EFFECTS OF EXPANSIONARY FISCAL POLICY ON REAL GROSS DOMESTIC PRODUCT AND PRICE LEVEL
Real gross domestic product (GDP) and price level are determined by interactions between aggregate demand (AD) and short-run aggregate supply (SAS). In turn, consumption expenditures, investment expenditures, government expenditures, and net exports determine AD. Some of these expenditures are interest rate-sensitive. The interaction between money supply (MS) and money demand (MD) determines the interest rate.
The principal tools of fiscal policy are government-spending, taxes, and transfer payments. An expansionary fiscal policy involves (a) increased government spending, (b) decreased taxes, (c) increased transfer payments, or (d) some combination of increased government spending, decreased taxes, and increased transfer payments.
An expansionary fiscal policy has both short-term and longer-term effects. The short-term effects of an expansionary fiscal policy are (a) an increase in AD, which leads to (b) an increase in GDP (y) and (c) an increase in the price level. Very soon, however, the increase in GDP results in an increase in MD, which, in turn, leads to an increase in the interest rate. The increase in the interest rate leads to a reduction in interest rate-sensitive expenditures. Thus, the initial increase in GDP caused by the expansionary fiscal policy is moderated to some extent. In the short-term, however, an expansionary fiscal policy caused both real GDP and the price level to increase.
An expansionary fiscal policy, however, also has an effect on investment expenditures. This effect is the process of crowding-out, which causes a reduction in investment expenditures. Crowding-out occurs when fiscal policy affects interest-sensitive expenditures. When an expansionary fiscal policy increases the demand for money while increases in the price level reduce the real value of money, ...