Policy Mix

What Is a Policy Mix?

The term policy mix refers to the combination of fiscal and monetary policy that a country uses to manage its economy. A policy mix is developed and determined by a nation's policymakers — notably its federal government and central bank. The policy mix is a pivotal part in boosting a nation's economic growth and helps keep the country on track to maintaining the strength of its economy.

How a Policy Mix Works

A country's economic policy consists of two components — its fiscal policy and its monetary policy. A fiscal policy consists of any spending plans and tax initiatives that a nation's government uses to boost and influence economic conditions such as inflation, employment, and demand for goods and services. Monetary policy, on the other hand, refers to any actions taken to control a country's supply of money. Monetary policy is supposed to help the nation sustain economic growth.

In most democratic countries, elected legislatures — the federal government — control fiscal policy, while independent central banks handle monetary policy. In the United States, this is the Federal Reserve System (Fed), which is made up of a dozen regional Federal Reserve Banks. Governments and central banks generally share a broad set of goals. They include low unemployment, stable prices, moderate interest rates, and healthy growth.

These policymakers may employ different tools to accomplish these goals and often stress different priorities. For instance, government budgets affect long-term interest rates, while monetary policy affects short-term ones. That's because they each have different objectives and time horizons to accomplish their goals. Governments must win popular approval from the general public and are generally voted for in four-year cycles, while central bankers are technocrats that don't directly answer to voters. This makes them much more independent.

If you pay a lot of interest on your credit card during a low interest rate environment, you may be able to negotiate a better rate with your lender if you've been a really great customer.

So how does this all work? Inflation occurs when prices rise and the purchasing power of a single unit of currency declines. This means people can't afford to buy goods and services because their money doesn't stretch as far as it once did — prices are just too high. This situation spreads throughout the economy, leading to a drop in consumer and business spending and higher unemployment, to name a few effects. A nation's federal government and central bank may step in to help curb inflation through a policy mix. For instance, the government may implement tax cuts to encourage consumers to spend more money while its central bank may reduce interest rates to inject more liquidity in the financial market. The central bank may also increase the money supply to boost investment and also encourage spending.

Special Considerations

There are times when fiscal and monetary policymakers actually work together. For example, the government may pass fiscal stimulus by cutting taxes and increasing spending. The central bank may decide to provide monetary stimulus by cutting short-term interest rates. Broadly speaking, this was the policy mix that characterized the response to the 2008 financial crisis in the United States. The crisis was ushered in by a collapse in the housing market, rising interest rates, defaulting subprime borrowers. This had a domino effect that led to a crash in the global financial market, ultimately resulting in the Great Recession.

Fiscal and monetary policy can also push in different directions. The central bank might ease monetary policy while fiscal policymakers pursue austerity measures. This is what happened in Europe following the financial crisis. Or the government, eager to win popular support, may decide to cut taxes or boost spending despite a tight labor market and inflationary pressures. These actions could force the central bank to raise interest rates.