An economy in recession produces below its potential, leaving idle labor and capital. Policymakers can use expansionary fiscal policy and expansionary monetary policy together to raise aggregate demand (AD) and return to full employment.

Core idea: close a recessionary gap by increasing AD

In the AD–AS model, a recessionary gap occurs when the intersection of AD and SRAS produces real GDP $Y_1$ that is less than potential GDP $Y^*$.

The policy goal is to shift AD right until equilibrium output returns to $Y^*$ (full employment). In the short run, closing the gap typically raises the price level because SRAS slopes upward.

What expansionary fiscal policy does (demand-side)

Expansionary fiscal policy increases AD directly and indirectly:

• Increase government purchases (G): Directly raises AD because G is a component of AD.

• Cut taxes (T) / raise transfers: Increases disposable income, boosting consumption (C); the AD shift depends on households’ marginal propensity to consume and saving behavior.

A key channel is the multiplier, where an initial rise in spending leads to further rounds of income and consumption.

Fiscal policy’s strength depends on how much of new income is spent versus saved, and how much spending leaks into taxes and imports. Fiscal expansion can also increase government borrowing needs, which matters for interest rates if monetary policy does not accommodate.

What expansionary monetary policy does (interest-rate channel)

The central bank (the Fed) can increase the money supply using tools such as:

This flow diagram traces an open market purchase: the Fed buys government securities (bonds) and injects money that ultimately raises bank reserves. Higher reserves support an expansion of the money supply and put downward pressure on short-term interest rates. In the AD–AS story, that lower interest rate helps increase investment spending, reinforcing a rightward shift in aggregate demand. Source

• Open market purchases of government securities (most common): increases bank reserves and the money supply.

• Lower the discount rate: encourages bank borrowing from the Fed, supporting reserve growth.

• Lower reserve requirements: allows banks to lend a larger share of deposits (rarely used).

With more money available, interest rates tend to fall, making borrowing cheaper. Lower interest rates stimulate investment (I) and often interest-sensitive consumption (e.g., durable goods, housing), shifting AD right.

Why combine the two policies?

Using both policies can close a recessionary gap more effectively than using either alone:

• Fiscal policy provides a direct boost to AD (especially via higher G).

• Monetary policy supports the expansion by lowering interest rates, strengthening private-sector spending (especially I).

Coordination and “crowding out” in a recession

If fiscal expansion is financed by borrowing, interest rates might rise, reducing private investment (crowding out). When the Fed also uses expansionary monetary policy, it can offset upward pressure on interest rates, helping maintain or increase investment while AD rises. This policy mix is commonly described as monetary policy accommodating fiscal expansion.

What you should be able to show on a graph

On an AD–AS diagram for a recessionary gap:

• Start at $Y_1<Y^*$ with AD intersecting SRAS left of LRAS.

• Apply expansionary fiscal and/or monetary policy: AD shifts right from $AD_1$ to $AD_2$.

• New short-run equilibrium is closer to (or at) full-employment output $Y^*$, with a higher price level than initially.

Policy success is defined by restoring full employment (closing the gap) while recognizing that the short-run trade-off typically involves some increase in the price level as AD rises.