The Policy Mix: Coordinating Fiscal and Monetary Actions

When the government uses Expansionary Fiscal Policy ($G \uparrow$ or $T \downarrow$), it aims to increase Aggregate Demand ($AD$). However, if the Central Bank simultaneously implements Contractionary Monetary Policy ($MS \downarrow$ or $i \uparrow$) to prevent inflation, a conflict arises. This specific 'Policy Mix' leads to a massive increase in interest rates. While the fiscal side tries to push output ($Y$) up, the high interest rates from the monetary side discourage private investment, a phenomenon known as Crowding Out. The net effect on GDP becomes uncertain, but the cost of borrowing is guaranteed to rise.

Standard policy assumes an inverse relationship between inflation and unemployment (the Phillips Curve). However, Stagflation—a combination of stagnant growth and high inflation—breaks this rule. If you use expansionary policy to fix unemployment, you trigger hyper-inflation. If you use contractionary policy to fix inflation, you cause a deep recession. This occurs when the Short-Run Aggregate Supply ($SRAS$) shifts left, often due to a 'supply shock' like a sudden spike in energy prices.

To achieve long-term stability, fiscal and monetary actions must be coordinated. A Balanced Mix occurs when both move in the same direction to tackle a single goal. However, in an advanced economy, the Central Bank is usually independent to prevent politicians from over-stimulating the economy before elections. The ideal mix for long-term growth often involves Fiscal Discipline (low deficits) to keep interest rates low, paired with Accommodative Monetary Policy to encourage private investment ($I$).