Policy Mix

A policy mix refers to a combination of fiscal and monetary policies that a country implements to manage its economy.  

Implementing a policy mix means the country’s central bank and elected government will adopt different strategies and tools at the same time to accomplish shared goals.

How a policy mix works

A country’s economic policy consists of its fiscal and monetary policy. In most democratic countries, the elected government legislatures are in charge of fiscal policy, while independent central banks manage monetary policy. In the US, the central bank is known as the Federal Reserve (the Fed).

Although the government legislatures and central banks are from two different branches, they often share a common set of goals, such as low unemployment rate, healthy economic growth, moderate interest rates and stable prices.

Through fiscal policy, the government will determine the level of spending and taxation to influence the country’s economic conditions, such as aggregate demand for goods and services, employment, inflation and economic growth.

The monetary policy is shaped by a country’s central bank, which controls the overall supply of money and credit available to banks, consumers and businesses. The main tool available to central banks is interest rates. If the central bank increases interest rates, it will likely encourage savings and reduce borrowing and spending. In contrast, a lower interest rate will likely encourage borrowing from businesses, including for mortgages for home buyers. A lower interest rate may incentivise investment by businesses as the cost of borrowing falls.

Example of a policy mix

Policy mixing has been repeatedly adopted as a measure to tackle economic crises throughout the 21st century. During the 2008 financial crisis in the US, the rising interest rates led to a mass default on subprime mortgages, eventually culminating in the collapse of the housing market in the country. The effect of the collapsed housing market spilled over to the broader financial market, leading to a recession.

In response to the economic crisis, the central bank eased monetary policy by cutting interest rates, while fiscal policy makers implemented years of austerity measures, such as cutting government spending.

As fiscal policy makers are elected legislators, in order to win support, their decisions can be influenced by popular sentiments. For example, governments may increase spending despite a tight labour market and high inflation or cut taxes. This will in turn compel the central bank to raise interest rates to counter the effect of those fiscal policies.   

The Covid-19 pandemic

The Covid-19 pandemic, which started in early 2020, caused huge economic damages globally, as countries implemented months of lockdown measures, which led to drastically reduced productivity and disrupted supply chains.

In response to the crisis, the US and many EU countries’ fiscal and monetary policymakers coordinated to provide economic stimulus by cutting interest rates, and increased spending in the form of financial assistance to people affected by the pandemic.