Policy mix and trade-offs: fiscal and monetary stance controls driving a labelled Phillips curve or aggregate demand and supply diagram, with a short-run and long-run view
Two tools pulling in opposite directions can be the smartest mix
Fiscal and monetary policy each shift aggregate demand, so what matters is the combined stance, not either tool on its own. Opposite stances can keep spending programs alive without overheating the economy, at a price paid through the currency (the dollar index reads 100 for a neutral mix). Set fiscal policy loose and monetary policy tight, then watch where the dot lands and which way the dollar index moves.
Policy mix model
Phillips curve · short run
Set each stance. Watch the dot, the curve and the three readouts.
View
Both neutral
Fiscal stanceNeutral
LooseNeutralTight
Monetary stanceNeutral
LooseNeutralTight
Inflation
2.5%
Unemployment
4.5%
Dollar index
100
Time horizon
In the short run the two tools add up to one shift of aggregate demand. A loose budget and a low cash rate both push spending up, so output climbs above potential, unemployment falls and inflation rises: the economy moves up and to the left along the short-run Phillips curve. Pull both tools tight and it slides down and to the right. Mixing them is where the trade-offs get interesting: loose fiscal with tight monetary keeps the big spending programs but holds total demand steady, while high interest rates pull in foreign capital and push the dollar up, which hurts exporters. Fiscal policy can aim at particular sectors but widens the deficit and takes time to pass; monetary policy reaches the whole economy quickly but loses power near the zero lower bound.