Stabilization Policy in Economics

Stabilization Policy

• John Maynard Keynes famously said, "in the long run, we are all dead."
• In the long run, output and employment ideally reach full employment levels.
• This is desirable as there's no need to manage demand in the long run.
• However, the short run is unstable, with economies facing unexpected events like disturbances and shocks.
• The COVID-19 pandemic is an example of a shock affecting global demand and supply.
• Policymakers need to develop policies to help the economy adjust after such shocks.

Types of Shocks

• Demand shocks: These affect the AD curve, like an expansionary monetary policy or reduced government deficits.
• Supply shocks: These affect the supply-side, impacting the labor market and pricing decisions of firms.

Sources of Instability

• Shocks can happen in two ways:
  • Changes in variables in the economic model, like shifts in exports or autonomous investment.
  • Changes in behavioral parameters, such as a shift in consumer spending due to a change in thriftiness.

Should Policymakers Intervene?

• There are differing views:
  • Some believe in intervention, stimulating the economy during recessions and curbing it during booms.
  • Others believe the economy is naturally stable, with large fluctuations stemming from bad policy.

Active vs. Passive Policy

• Active policy: Monetary and Fiscal policy intervention to stabilize the economy.
• Passive policy: "hands-off" approach, letting the economy adjust naturally.

Arguments for the Passive Approach

• Lags in policy implementation and impact:

  • The economy typically reacts with a time lag to policy changes.
  • Policy responses can be unpredictable.
  • The inside lag is the time between a shock and a policy response.
  • The outside lag is time between a policy action and its economic effect.

• Challenges in Economic Forecasting: Authorities must accurately predict future economic conditions, using leading indicators. The success depends on how well forecasts are modeled.

• Expectations and the Lucas Critique: Economists need to understand how economic agents' expectations respond to policy actions.

  • Households and businesses make decisions about consumption and investment based on these expectations.

• Historical record: Policymakers should base their interventions on historical success or failure of previous policies. Previous successful intervention does not guarantee future success.

Automatic Stabilizers

• Policies that automatically respond to economic conditions without intervention, reducing the lags associated with stabilization policy.
• Progressive taxes are an example: taxes are reduced automatically when incomes are low.

Should Policy be Conducted by Rule or Discretion?

• Rule-based policy: The central bank commits to a particular inflation rate and policy stance.
• Discretionary policy: Policymakers respond to circumstances as they arise..

Advantages of a Policy by Rule

• Distrust of policymakers: A rule can foster trust if policymakers are perceived as incompetent or opportunistic.
• Time inconsistency/lack of credibility: A policy rule is consistent over time and builds credibility when policy responses are linked to specific economic conditions.

Rules for Monetary Policy

• Maintaining steady growth of money supply:
  • Monetarists believe in controlling the rate of money supply but the stability of velocity is important.
• Nominal GDP targeting:
  • Setting a targeted path for nominal GDP, prompting policy adjustments when levels deviate.
• Inflation targeting:
  • The central bank sets an inflation target and responds to deviations from the target.