Fiscal and monetary policy in IS–LM

The government raises its spending. In the Keynesian cross, output would rise by the full multiplier. In IS–LM, something pushes back. Follow the chain (UGC NET 2024 asked for exactly this order):

1. Demand for goods rises, so output and income rise.
2. Higher income raises the transactions demand for money; money demand now exceeds the fixed supply.
3. People sell bonds to get money; bond prices fall.
4. A lower bond price means a higher interest rate, and the higher rate cuts private investment.
5. Lower investment pulls income back down part of the way.

Step 4 is crowding out: public spending displaces some private investment through the interest rate. Output still rises, but by less than the simple multiplier, and the interest rate ends higher (UGC NET 2025). That is why the simple Keynesian model overstated the effect of an increase in government spending (CUET 2018).

Choose fiscal or monetary policy, then change the slopes. The hollow dot shows where output would go if the interest rate did not move; the gap between it and the new equilibrium is what the interest rate takes away. The four buttons are the textbook extremes.

Differentiate Lesson 4’s solution for Y* with respect to G and to M/P:

The fiscal multiplier is the Keynesian-cross one with an extra term in the denominator. When bk/h vanishes (h infinite or b zero), it reaches its maximum, 1/(1 − c(1 − t)) (CUET 2023). When h is zero it falls to zero. GATE 2026 asked for the investment multiplier in exactly this model; since a rise in autonomous investment shifts IS just as G does, the answer is the same expression.

Fiscal policy shifts IS along LM, so it works best when LM is flat: the interest rate hardly rises and little is crowded out. Monetary policy shifts LM along IS, so it works best when IS is flat: a small fall in the rate brings a lot of investment. The rules:

UGC NET 2023 set this as a match: investment unresponsive to interest → vertical IS; money demand perfectly elastic → horizontal LM; money demand completely inelastic → vertical LM; investment highly responsive → flat IS. And JAM 2022’s false statement was that monetary policy is weak when money demand is not very interest-responsive; it is the opposite.

Because each policy moves one curve, combining them lets the authorities choose where the new equilibrium lies. To raise output without raising interest rates, expand both: IS right and LM right together (Hyderabad 2010). To pull an economy out of recession, raise government spending and cut interest rates (Hyderabad 2019). Some combinations have a clear effect on one variable only:

• A tax cut with a cut in the money supply: IS right, LM left. The rate certainly rises; output could go either way (Hyderabad 2010).
• A higher tax rate with the money supply held constant: IS shifts left, so the rate falls (Hyderabad 2013).
• More government spending and a cut in the money supply: opposite effects on output, the same effect (a rise) on the rate (JNU 2015).
• Spending financed by printing money shifts both curves right: output rises for sure (Hyderabad 2010).

Fiscal policy means the government’s decisions on taxation, spending and borrowing; the repo rate and money supply are monetary tools (CUET 2019, 2022; Hyderabad 2010, 2011). A larger fiscal deficit raises spending, pushes up domestic interest rates and can lower private investment (UGC NET 2025).

Some stabilisation happens without anyone deciding it. A progressive income tax takes more when incomes rise and less when they fall, and unemployment benefits do the reverse: these automatic stabilisers damp both recessions and booms (JNU 2018; DSE 2010).

Borrowing has a limit. If the interest rate on public debt exceeds the growth rate of the economy, the debt ratio rises unless the government runs a primary surplus: that is when debt becomes unsustainable (CUET 2026).

Suppose the government cuts taxes today and borrows to pay for it. Barro (1974), reviving an argument of Ricardo’s, pointed out that the debt must be repaid with higher taxes later. Households who see this save the whole tax cut to pay those future taxes. Consumption, today and later, does not change (DSE 2016; Hyderabad 2020), and neither does IS. Whether taxes or borrowing finance spending is then irrelevant. It relies on households looking far ahead, borrowing freely and caring about the taxes their heirs pay; most evidence finds partial effects at most.

Modern central banks set an interest rate rather than a money stock, so LM is horizontal at the chosen rate (Lesson 3). How do they choose it? John Taylor (1993) showed that the US Federal Reserve behaved roughly as if it followed a simple rule: raise the nominal rate when inflation is above target and when output is above potential (JAM 2026; UGC NET 2023).

The three-equation model used in newer textbooks (UGC NET 2023) puts this together: an IS curve linking output to last period’s real interest rate, a Phillips curve (Lesson 7), and a monetary rule derived from a central bank loss function L = (y − y_e)² + β(π − π^T)².

India adopted flexible inflation targeting in 2015–16: the RBI targets 4% CPI inflation within a band of 2% to 6% (JAM 2025), as do New Zealand and the UK with their own targets (Hyderabad 2021). Its policy rate is the repo rate; the marginal standing facility rate sits above it and the reverse repo rate below (JAM 2026).