Stabilization Policy Definition

What is the stabilization policy?

Stabilization policy is a strategy implemented by a government or its central bank which aims to maintain a healthy level of economic growth and minimal price variations. Maintaining a stabilizing policy requires monitoring the business cycle and adjusting fiscal and monetary policy as needed to control sudden changes in demand or supply.

In the parlance of economic news, a stabilization policy is designed to prevent the economy from excessively “overheating” or “slowing down”.

Key points to remember

  • Stabilization policy aims to keep an economy in balance by raising or lowering interest rates as needed.
  • Interest rates are raised to discourage borrowing to spend and lowered to stimulate borrowing to spend.
  • Fiscal policy can also be used by increasing or decreasing government spending and taxes to influence aggregate demand.
  • The expected result is an economy that is cushioned from the effects of wild swings in demand.

Understanding Stabilization Policy

A study by the Brookings Institution notes that the US economy has been in recession for about one in seven months since the end of World War II. This cycle is considered inevitable, but the stabilization policy seeks to cushion the shock and prevent widespread unemployment.

A stabilization policy aims to limit erratic fluctuations in the economy’s total output, as measured by the country’s gross domestic product (GDP), as well as controlling inflation or deflation surges. Stabilization of these factors generally leads to healthy employment levels.

The term stabilization policy is also used to describe government action in response to an economic crisis or shock such as a sovereign debt default or a stock market crash. Responses may include emergency action and law reform.

The foundations of the stabilization policy

Pioneer economist John Maynard Keynes argued that an economy can experience a period of acute and sustained stagnation without any type of natural or automatic rebound or correction. Previous economists observed that economies grow and contract in a cyclical pattern, with occasional downturns followed by recovery and a return to growth. Keynes challenged their theories that a process of economic recovery should normally be expected after a recession. He argued that the fear and uncertainty facing consumers, investors and businesses could induce a prolonged period of reduced consumer spending, slower business investment and high unemployment, which would be mutually reinforcing in a vicious circle.

In the United States, the Federal Reserve is responsible for raising or lowering interest rates to keep the demand for goods and services stable.

To stop the cycle, according to Keynes, policy changes are needed to manipulate aggregate demand. He and Keynesian economists who followed him also argued that the reverse policy could be used to combat excessive inflation during periods of optimism and economic growth. In Keynesian stabilization policy, demand is stimulated to counter high levels of unemployment and it is suppressed to counter rising inflation. The two main tools used today to raise or lower demand are to lower or raise interest rates for borrowing or to raise or lower government spending. These are known as Monetary Policy and tax policyrespectively.

The future of stabilization policy

Most modern economies employ stabilization policies, with much of the work done by central banking authorities such as the US Federal Reserve. The stabilization policy is widely credited with the moderate but positive GDP growth rates observed in the United States since the early 1980s. This is to use expansionist monetary and fiscal policy during recessions and restrictive policy during periods of excessive optimism or rising inflation. This means lowering interest rates, reducing taxes and increasing deficit spending during economic downturns and raising interest rates, raising taxes and reducing government deficit spending during better times.

Many economists now believe that maintaining a steady pace of economic growth and keeping prices stable are essential to long-term prosperity, especially as economies become more complex and advanced. Extreme volatility in any one of these variables can lead to unintended consequences for the economy as a whole.

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