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    Relation Between Fiscal and Monetary Policy

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    What's wrong with the following statement? Whenever fiscal policy makers increase the budget deficit, monetary policy makers should increase the money supply in order to maintain a low, stable rate of inflation.

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    If the budget deficit is increasing and the central bank decides to increase money supply it will have two effects. One increasing budget deficit implies that the government spending is rising: and hence AD is rising. Now depending on where the economy is to begin with, the central bank will either have to raise or lower interest rates.

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    Solution Summary

    The solution examines the nuanced relation between fiscal and monetary policies and shows how they should be used as complements and not substitutes.