Stabilization policy

Updated: Aug 20, 2021

The name given to the measures which governments take to reduce the extent of fluctuations in economic activity. Left to themselves, free market capitalist economies tend to exhibit over time cyclical fluctuations in national income and employment. The determinants of the timing and amplitude of these fluctuations are analysed in that part of economics known as the theory of the trade cycle. As the economy approaches the ‘peak’ of a cycle, there is rapid wage and price inflation, imports rise relative to exports, and balance of payments deficits occur. On the other hand, in the ‘trough’ of a cycle, unemployment is high and business profits are down. Hence, the aim of stabilization policy is to restrain the economy when it is nearing the peak of the cycle, and to stimulate the economy when it approaches the trough. Because of the alternation between restraint and stimulation which the policy implies, it has earned the name ‘stop-go’.

The principal instruments of stabilization policy are monetary policy and fiscal policy, and the policy is facilitated by the existence of built-in stabilizers. Stabilization policy is not so straightforward and simple as its description might suggest. Not only are there limitations arising out of the bluntness of the instruments available, but the imperfections in the information available to the managers of the economy also create serious difficulties. These im­perfections may interact with certain time-lags which exist within the system, so that stabilization policy may actually be destabilizing. We could divide the overall time period which elapses between the time an event requiring correction occurs and the time a corrective measure takes effect into three phases: (a) the time between the occurrence of the event and the recognition that corrective action is required (this depends, among other things, on the time-lags in information flow); (b) the time between recognition of the need for action and actually taking action (which depends on the speed with which the policy-making processes work, the administrative arrangements for putting policy into effect, etc.); and (c) the time between the action and the impact of that action on the variables under consideration (which depends on the time-lags in the institutional and behavioural relationships in the economy). Given the existence of these time-lags, it is generally pointless to take action to correct something which is currently happening. Rather, current events must be used to predict future events, and then the policy measures must be designed to influence these. But this, of course, involves the difficulty that the future can never be predicted completely accurately. But, even worse than this, the knowledge of the present is based on estimates of national income magnitudes; consumption, investment, exports, imports, etc. and since these estimates are known to contain (sometimes considerable) errors, knowledge of the present is also extremely imperfect. Predictions about an uncertain future have to be made on the basis of an incompletely known present. The costs of inappropriate policies may be high. Suppose, e.g., that measures designed to restrain ‘overheating’ in the economy come into effect just as the economy is past the peak and beginning to turn down. The measures will then accelerate the downturn, and cause income and employment to fall farther and faster tban they might otherwise have done. It is considerations sucb as this which make stabilization policy more of an art than a science at the present time, and which lead several prominent econornists to argue tbat stabilization policy is in fact impossible to carry out.

Reference: The Penguin Dictionary of Economics, 3rd edt.

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James Knight
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