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Chapter 5

Fiscal policy and monetary policy

5.1. Fiscal policy
1) Definition and objectives of fiscal policy:
- Fiscal policy is the macroeconomic policy consisting of solutions for adjusting the
government’s income and expenditure to drive the economy into expected output and
employment rate.
- The government uses tax rates and public expenditures to moderate the economy’s
expenditure and drive the economy into the potential output. Fiscal policy is represented
within the process to establish, approve and perform the annual state budget
- Tax is the major source of revenue of the state budget (T); the government’s
expenditures for goods and services are the major component of the state budget
spending (G) → T – G: The government budget balance
→ (1) T – G > 0 → Budget surplus; (2) T – G < 0 → Budget deficit; (3) T – G = 0 → Balanced
Budget

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2) Tools and the impact mechanism of active fiscal policies
- Tools of fiscal policies: Taxes and spendings of the goverment
- The impact mechanism of active fiscal policies
+ 1st circumstance: The economy is in a recession and unemployment
situation and AD of the economy is in very low level.
→ The government increases its spending and decreases its taxes (to
attract investments) → Investment increases → The economy’s output
increases (based on Keynesian multiplier model), and the employment
increases → the unemployment decreases.
+ 2nd circumstance: The economy is in an over-prosperity situation, AD of
the economy is in very high level and inflation increases
→ The government decreases its spending and increases its taxes → The
economy’s output decreases to the potential one.

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3) Features of fiscal policies in reality:
+ It is very hard to exactly define the appropriate amount of increase or
decrease on the government spending as well as the appropriate amount
of decrease or increase on its taxes
+ Fiscal policies possess considerable lags (or the time for making decision
is very long) → the timely fiscal policies adjustment cannot be performed
→ Fiscal policies may be not working in monitoring the economy.
• Inside lags: the amount of time for information collecting and processing
and decisions making
• Outside lags: the process of popularizing, implementing and waiting for
the efficiency of fiscal policies
+ The fiscal policy is often implemented by means of infrastructure
projects funded by the state budget, employment development and social
grants, etc. but not every project shows efficiencies.
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4) Pro-cyclical and counter-cyclical fiscal policy
+ Pro-cyclical fiscal policy: Both the government’s policy on its spending
adjustment and the business cycle are cyclical (or follow the same direction)
* For ex. In case the economy is in a recession and a budget deficit situation, the
government decreases its spending or increases its taxes (or performs both 02
actions) to achieve the budget balance, however the output will decrease, and
the recession situation will keep spreading.
+ Counter-cyclical fiscal policy: the government’s policy on its spending
adjustment and the business cycle are counter-cyclical (or do not follow the
same direction)
* For ex. In case the economy is in a recession and a budget deficit situation, the
government increases its spending or decreases its taxes (or performs both 02
actions) to boost the output expansion and to achieve the potential output,
however the budget is more and more deficient (the structural deficit occurs due
to subjective policies).

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5.2. Monetary policy
1) Definition
- Monetary policy is the macroeconomic policy that influences private
investments for driving the economy into expected amounts of output and
employment.
- Monetary policy consists of solutions and the government’s macro-
management tools on money established and implemented by State bank to
create a stable currency, attract private investments, boost the economic
growth and deal with unemployment
- 02 kinds of common monetary policies:
(1) A loose monetary policy: increasing the monetary supply to decrease the
interest rate and attract investments and consumptions
(2) A tight monetary policy: keeping the monetary supply at a low level, and
increasing the interest rate or keeping it stable to reduce investments and
consumptions
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2) Definition and functions of money
- Definition: the strong development of commodity production and trade
creates a special good with the role of a commodity equivalent →
Money’s definition
Money is an intermediate tool for the process of trading goods or services
in the economy.
- Functions of money: 03 functions: (i) The Basis of Credit, (ii) A Store of
Value and (iii) A Unit of Account.

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 3) Money supply(MS):
MS = Total amount of money that can be used for liquidation: MS = U + D
• U: Cash in circulation
• D: Demand deposits in commercial banks
The amount of money issued by State bank (monetary base) is called H, reserves of commercial banks is R:
H=U+R
MS/H = mM → MS = mM . H, where mM is monetary multiplier
1+𝑠
Ra is the real reserves in commercial banks; s is the rate of U and D: s = U/D and ra = Ra/D → mM =
𝑟𝑎 +𝑠
→ mM depends on ra: the less ra is, the larger mM is and vice versa
𝟏+𝒔
MS = mM . H = .H
𝒓𝒂 +𝒔
→ Money supply (MS) depends on monetary base (H) and monetary multiplier (mM ) or depends on
monetary base (H) and real reserves (ra).
→ State banks will control the monetary base (H) and the monetary multiplier (mM ) to control the money
supply quantity (M0) that does not depend on interest rate (i) for the monetary market → MS curve is
straight line that is parallel to the I axis at the money supply quantity of M0.
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4) Demand for money (MP):
Demand for money (MP) is the necessary amount of money to
normally expenditure for personal consumption needs, business and
production, etc. in the economy
• MP depends on:
+ Income Y: Y ↑↓ → Consumption ↑↓ → MP ↑↓
+ interest rate i = Opportunity cost of reserving money: i ↑↓ →
reserving money ↓↑ → MP ↓↑
• Demand for money function: MP = f(i) = k.Y – h.i
Where k, h: indicates on the sensitivity of MP to income (Y) and
interest rate (i)
→ Demand for money curve (MP) is the straight line that slopes to
the right

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5) Money market equilibrium
- The equilibrium point of the monetary market is the intersection point between
the money supply curve and the money demand curve. The interest rate
corresponding to the equilibrium point is called Equilibrium interest rate.
- MS line or MP line or two of them shifting will create the change in the
Equilibrium interest rate of the monetary market

MS MS’

i1

i0
MP MP’
i2 LP LP’

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5.2. Collaboration between fiscal policy and monetary policy
1) Model IS – LM
- IS line represents various combinations of interest rate
and income (output) that are appropriate to the
commodity market.
* IS line reflects equilibriums of the commodity market.
i ↑↓ → Aggregate demand↓↑ → Y ↓↑ → IS tends to
slope down to the right
- LM line represents various combinations of interest rate
and income (output) that are appropriate to the
monetary market.
At a fixed money supply quantity: Y ↓↑ → i ↓↑ → LM
line tends to slope upward.
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2) Principles of the Collaboration between fiscal policy and monetary
policy
- Fiscal policies (taxes and spending of the government) indirectly affect
the consumption (C) and investments (I) → directly affect the economy’s
aggregate demand.
- Monetary policies (decisions on money supply quantity) directly affect
the monetary market, then affect the consumption (C), export (X) and
investment (I) → indirectly affect the economy’s aggregate demand.
→ Both fiscal policies and monetary policies affect the aggregate demand,
but each kind of policies has a different influence on the aggregate
demand.
→ a good collaboration of 02 these policies provide an effect management
of the economy’s aggregate demand, so the economy’s income (output)
will be stable at an expected value.

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• Simultaneous equilibrium of the commodity market and the
monetary market: is represented by the intersection point (O)
between IS and LM line.
• At the point O, interest rate io and amount of output Yo are defined,
these 02 indicates occurs in case the commodity market and the
monetary market are simultaneously in the equilibrium.
i
LM
O
io
IS

Yo Y
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• Loose fiscal policy: Increasing the government’s spending or
decreasing taxes → IS line shifts to the right → Both income and
interest rate increase
• Tight fiscal policy: Decreasing the government’s spending or
increasing taxes → IS line shifts to the left → Both income and
interest rate decrease
• Loose monetary policy: Increasing the money supply → LM line shifts
to the right → interest rate decreases and income increases
• Tight monetary policy : Decreasing the money supply → LM line
shifts to the left → interest rate increases and income decreases

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• Principles of the Collaboration between fiscal policy and monetary policy to positively
impact on the aggregate demand: (1) define the overall objectives of both 02 policies and (2)
establish and apply couples of policies that have the same objectives
• Example:
+ 1st ex: In case the aggregate demand is at a very low level:
• Overall objective: Increasing the aggregate demand to expand outputs and to avoid the
investment withdrawal.
→ Apply the policy: loose fiscal policies (for ex. Increasing public investments) and loose
monetary policies (for ex. Increasing the money supply quantity)
→Impacts of the policy: increasing public investments → the aggregate demand increases → IS
line shifts to the right; the money supply quantity increases → the aggregate demand
increases → LM line shifts to the right. So, output increases strongly but interest rate is kept
stable
+ 2nd ex: In case the aggregate demand is at a high level :
* Overall objective: Decreasing the aggregate demand
→ Apply the policy: tight fiscal policies and tight monetary policies
→ Impacts of the policy: IS and LM shift to the left. So, output decreases but interest rate is
kept stable

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TRƯỜNG ĐẠI HỌC XÂY DỰNG
KHOA KINH TẾ VÀ QUẢN LÝ XÂY DỰNG www: [Link]

Chapter 5’ exercises
(Fiscal policy and monetary policy)
(1) Questions
1. Definition and functions of money?
2. Please explain why the government often want to strictly control the
amount of money in circulation (or control the money supply quantity)?
What are tools often used to control the money supply in Vietnam?
3. What is the government budget balance, a budget surplus, a budget
deficit and a balanced budget?
4. Describe pro-cyclical fiscal policies and counter-cyclical policies
5. What is tight (loose) fiscal policies and tight (loose) monetary policies?
6. Describe the collaboration between fiscal policy and monetary policy to
positively impact on the aggregate demand. How was this collaboration
performed in Vietnam?
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(2) Multiple choices questions
Choose the best answer for following questions:
1) The value of monetary multiplier increases in case:
a. Commercial banks increase their lending and c. The ratio of Cash outside
decrease their reserves banks rate to deposits
b. The required reserve ratio decreases and decreases
reserves of commercial banks always equal this d. a, b, c occurs together.
ratio
2) In case of unchanged other factors and the money supply quantity decreases:
a. Interest rate decreases, investment c. Interest rate increases, investment
increases decreases
b. Interest rate decreases, investment d. All answers above are wrong
decreases
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3) The initial impact of loose fiscal policies is create the increase of output, then the
money demand:
a. increases and interest rate increase c. increases and interest rate decrease
b. decreases and interest rate increase d. decreases and interest rate decrease
4) In case the government increase its spending
a. IS line is not affected c. IS line shifts to the left
b. IS line shifts to the right d. There is a movement along the IS line
5) In case the government increase its taxes:
a. IS line shifts to the left c. IS line is not affected
b. IS line shifts to the right d. There is a movement along the IS line
6) In case the state bank increase its money supply:
a. IS line shifts to the right c. LM line shifts to the left
b. LM line shifts to the right d. There is a movement along the LM line

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7) In IS-LM model, in case LM line does not shift while IS line shifts to the right:
a. Equilibrium output and interest rate c. Equilibrium output increases and
increase Equilibrium interest rate decreases
b. Equilibrium output and interest rate d. Equilibrium output decreases and
decrease Equilibrium interest rate increases

8) In IS-LM model, in case the loose fiscal policies and loose monetary policies are
applied:
a. Equilibrium output definitely increase c. Equilibrium interest rate definitely increase
b. Equilibrium output definitely decrease d. None of above
9) In IS-LM model, in case the loose fiscal policies and tight monetary policies are
applied:
a. Equilibrium output definitely increase c. Equilibrium interest rate definitely increase
b. Equilibrium interest rate definitely d. None of above
decrease
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(3) True/False/Not sure questions
1) The monetary multiplier only depends on the required reserve ratio
2) The required reserve ratio increasing will block commercial banks’ operation,
therefore, the money supply quantity will decrease in the economy.
3) The required reserve ratio increasing will make the money supply curve to shift
to the left, therefore the interest rate increases
4) The government increasing its taxes (t) is the reason for the parallel shift of IS
line to the left
5) In case the state bank increase its money supply quantity, LM line shifts to the
right and the interest rate decreases

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(3) True/False/Not sure questions
6) In case the nominal money supply quantity’s increase is faster than the price’s
increase, LM line shifts to the right and the interest rate decrease.
7) To boost the economic growth rate of the economy, the Government need to
apply loose fiscal policies and loose monetary policies.
8) In case the economy grows too fast, the government need to apply loose fiscal
policies and loose monetary policies.
9) In case the economy is in a recession situation, the government need to apply
tight fiscal policies and tight monetary policies.
10) To reduce the economy’s unemployment, the government need to apply
loose fiscal policies and loose monetary policies.

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(4) Writing questions
1) The economy’ data includes (interest rate is calculated by %, other indications’ unit is billion
USD): the real money demand function is LP = 2,700 -250i, the real money supply quantity M =
1,750.
Questions:
a. Calculate the equilibrium interest rate and draw the graph of the monetary market.
b. In case the real money supply quantity M1 = 1,850, calculate the new equilibrium interest
rate. How is the invesment going to change?
c. In case the interest rate (i) of State bank is 4.5%, calculate the money supply quantity? Draw
the graph for demonstration.
2) The economy’ data includes: the real money demand function is LP = kY –hi (where: k = 0.2; Y
= 2,500 billion USD; h = 10); the real money supply quantity M = 440 billion USD.
Questions:
a. Calculate the equilibrium interest rate and draw the graph of the monetary market
b. In case the income decrease by 50 billion USD, calculate the new equilibrium interest rate.
Describe this change by the use of the moneraty market’s graph.
c. In case the interest rate (i) of State bank is 4.5%, calculate the money supply quantity?

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