Interest Rates and Fiscal Policy Fiscal policy has a clear effect upon output. But there is a secondary, less readily apparent fiscal policy effect on the interest rate. Basically, expansionary fiscal policy pushes interest rates up, while contractionary fiscal policy pulls interest rates down. The rationale behind this relationship is fairly straightforward. When output increases, the price level tends to increase as well. This relationship between the real output and the price level is implicit. According to the theory of money demand, as the price level rises, people demand more money to purchase goods and services. Given that there is no change in the money supply, this increased demand for money leads to an increase in the interest rate. The opposite is the case with contractionary fiscal policy. When output decreases, the price level tends to fall as well. Again, this relationship between the real output and the price level is implicit. According to the theory of money demand, as the price level falls, people demand less
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