Stabilization Policy

Types of Stabilization Policy

The federal government employs two forms of stabilization policy: expansionary and contractionary fiscal policy. Expansionary policy stimulates economic growth when inflation falls under the rate desired by Congress and maximum capacity for employment is not achieved. Expansionary policy is when the federal government moves to lower taxes or increase spending to boost the economy.

If inflation rises over the amount desired by Congress, the federal government engages in contractionary policy. Contractionary policy is when the federal government increases taxes or reduces spending to slow the economy and reduce inflation.

The Federal Reserve (the central bank of the United States) also employs two forms of stabilization policy: expansionary and contractionary monetary policy. Expansionary policy stimulates economic growth when inflation falls under the rate desired by the central bank and maximum capacity for employment is not achieved. Expansionary policy is when the Federal Reserve moves to lower interest rates to boost the economy.

If inflation rises over the amount desired by the Federal Reserve, it engages in contractionary policy. Contractionary policy is when the Federal Reserve increases interest rates to slow the economy and reduce inflation.

Stabilization Policy Uses

By changing monetary policy, the Federal Reserve attempts to reduce disruptions to economic development and the stability of prices. It employs two forms of stabilization policy: expansionary and contractionary monetary policy. Expansionary policy stimulates the economy while contractionary policy limits the economy.

The Federal Reserve expands liquidity amid expansionary policy to stimulate spending and borrowing. Through contractionary policy, the Federal Reserve reduces liquidity in order to calm the economy, slow lending, and keep prices from increasing too rapidly.

Similarly, the federal government uses expansionary fiscal policy to boost demand, employment, and economic growth, and uses contractionary fiscal policy to reduce demand and economic growth. Although nobody wants to see a decline in employment, this is inevitable when the government is trying to reduce demand, which is usually done when inflation is too high. Unfortunately, no single policy can fix all problems. There are always pros and cons to consider and deal with.

Instruments of Stabilization Policy

The instruments used by the Federal Reserve have a direct effect on the markets and economy. These instruments are:

• Interest rates

• Control of credit/loans

• Requirements for cash reserve

The Federal Reserve controls interest rates by setting a target range for the overnight rate at which banks lend to each other, called the Fed Funds rate. It then buys and sells Treasury securities to increase or decrease the Fed Funds rate to keep it in the target range. This is done on a daily basis. Less frequent are changes in the target range itself, which is again done by buying and selling Treasury securities, otherwise known as open market operations. The Fed will increase interest rates if the economy or inflation are too hot, and decrease interest rates if the economy or job growth are too weak.

By controlling interest rates, the Fed also impacts demand for loans and credit from consumers and businesses. Higher interest rates will reduce demand for loans and credit, and lower interest rates will increase demand for loans and credit. Credit is the lifeblood of the economy, so the Fed has tremendous power to steer the economy in the direction it wishes.

Another policy instrument is the required reserve ratio, which is the percent of deposits banks need to keep in their vaults. A higher required reserve ratio means that banks have less money to lend, so this will cool the economy. A lower required reserve ratio means that banks have more money to lend, so this will help to strengthen the economy.

Stabilization Policy Economics

The measures used by a government to attain economic stability are referred to as stabilization policy. When the economy is weak, these policies' specific goals include putting money into the market, trying to make it simpler for consumers to borrow and spend cash, and assisting markets. Without the stabilization initiatives set out by the government, the economy would be forced to get back to normal on its own. The main disadvantage is that market forces don't cater to the wellness of single economic actors. This means that significant collateral damage can occur well before the economy is capable of correcting itself and getting back to normal.

These perilous situations illustrate the necessity of government involvement through stabilization policies. If the economy gets into trouble, the government may convene to deliberate on stabilization policies. Typically, stabilization policies are developed along with other government policies.

The business cycle is important when it comes to the stabilization of the economy. It pertains to the economy's ongoing booms and slumps. It is the most important aspect in determining the government's strategy for policy execution. Whenever the cycle reaches its apex, the government should potentially contemplate enacting policies to slow the economy. Whenever the cycle is in a slump, the government may consider actions to boost the economy.

In general, there are three basic approaches that a government may take to stabilize peaks and troughs in an economy, whether during a recession or simply to improve on the economy's present stability.

Sit Back

One strategy is to do nothing at all and let the economy repair itself. This isn't generally done in economic emergencies, but governments may contemplate it if the economy is only somewhat unstable. Rather than meddling, it's frequently better to let the powers of the market economy regulate the system.

Fiscal Policy

Fiscal policy is seen as the next technique a government may employ to stabilize an economy. Of all the options, this option is the most explicit kind of government intervention in the economy. It usually pertains to the utilization of taxes and government spending to control the overall amount of economic activity. Therefore, if unemployment (for example) is deemed excessive, taxes may be adjusted to boost aggregate spending.

Figure 1. U.S. Capitol Building, pixabay

Monetary Policy

Fiscal policy is strongly linked to the third technique, which is monetary policy. Monetary policy is focused on adjusting the money supply and interest rates in order to stabilize the economy at maximum employment or potential output by guiding aggregate demand. To specify, during a recession, monetary policy entails the use of a few financial tools (Fed Funds rate, required reserve ratio, open market operations) to boost the supply of money and decrease interest rates in order to encourage aggregate demand. Conversely, during an inflationary period, monetary policy strives to limit spending by reducing the supply of money and increasing interest rates.