Macroeconomics Essay Example | Topics and Well Written Essays - 1500 words - 4

Macroeconomics - Essay Example We begin by defining fiscal policy and monetary policy. The study later provides a description of the IS/LM model in section 3 and finally, an explanation of the crowding out effect using the IS/LM model. The last part of the paper will relate the crowding out effect to the real world particularly the UK as the Bank of England uses it as a fiscal policy tool. Fiscal policy refers to a situation whereby the government restores equilibrium in the economy by making changes to taxes or government expenditure on public goods and services (Smullen and Hand, 2005). When there is under-utilisation of capacity, the government can increase capacity utilisation by reducing taxes (that is through a reduction in tax rates or tax base) or by increasing spending on public goods and services as well as subsidising the production of certain goods and services (Smullen and Hand, 2005; Visser, 2004) Fiscal policy aimed at increasing money supply is referred to as easy fiscal policy (Smullen and Hand 2005). On the other hand, when there is over-utilisation of capacity, the government either increases taxes (through and increase in tax rates or tax bases) or reduces spending on public goods and services (Black 2002). It also reduces subsidies and transfer payments. This type of fiscal policy is referred to as tight fiscal policy (Black 2002). Monetary policy is referred to as a means by which the central bank tries to sway the economy to equilibrium by influencing the supply of money (Black 2002). This is achieved through four main approaches, which include: printing more money; direct controls over money held by the money sector; open market operations and influencing the interest rate. Both tight and easy monetary policies can also be identified. Like easy fiscal policy, easy monetary policy is one whereby the central bank embarks on a policy to increase the supply of money. On the other