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What do we mean by Long-Run Consequences of Stabilization Policies? First, we need to understand what stabilization policies are and what they are designed to do. Stabilization policies aim to prevent any major fluctuations in economic growth and prices. Stabilization policies have intended goals, but they can also have unintended consequences. But what exactly are those unintended consequences? Are they good? Bad? Both? These fundamental questions will help us understand the Long-Run Consequences of Stabilization Policies.
Stabilization Policy refers to the Monetary and Fiscal policies that are designed to maintain the desired level of economic growth and prices. The government controls fiscal policy through government spending and taxes. The central bank controls monetary policy through the money supply and interest rates. Both institutions have the same goal: to minimize recessionary and inflationary periods in an economy. A noble goal, but it comes with consequences that may be undesirable in an economy.
Examples of desirable stabilization policy outcomes are increased aggregate demand with the following: higher government spending, lower taxes, and lower interest rates. Examples of undesirable stabilization policy outcomes are the following: crowding out, deteriorated trade balance, and defaulting on debt.
Stabilization Policies refer to Monetary and Fiscal policies that are designed to maintain the desired level of economic growth and prices.
There are two types of stabilization policies that a government or central bank will utilize: Fiscal and Monetary Policy. Fiscal Policies focus on government spending and taxes, whereas Monetary Policies focus on the money supply and interest rates.
Governments will alter government spending or taxes when an economy is not in equilibrium. For example, an economy is not in equilibrium if it is going through a recession or an inflationary period. During a recession, the government will increase government spending and/or lower taxes to increase aggregate demand — this is known as Expansionary Fiscal Policy. In contrast, during an inflationary period, the government will decrease government spending and/or increase taxes to decrease aggregate demand — this is known as Contractionary Fiscal Policy.
Figure 1. Expansionary stabilization policy, StudySmarter Originals
As you can see in Figure 1 above, expansionary stabilization policies (both fiscal and monetary) will increase aggregate demand to get the economy into long-run equilibrium. This will increase the price level from P1 to P2 and output from Y1 to Y2.
Aggregate Demand refers to the total demand for all goods and services in the economy
The Phillips Curve
The Phillips Curve shows the relationship between unemployment and inflation. Higher inflation will lead to lower unemployment; higher unemployment will lead to lower inflation. When looking at the short-run and long-run Phillips Curve, based on where they intersect, we can locate the natural rate of unemployment. The stabilization policy graphs show the same idea as well. Increasing aggregate demand will lead to a higher output and lower unemployment but at the expense of increasing the aggregate price level in the economy.
Interested in this topic? Check our article - The Phillips Curve
The central bank can alter the money supply or the interest rate when an economy is not in equilibrium. During a recession, the central bank will increase the money supply to drive down the interest rates to increase aggregate demand — this is known as Expansionary Monetary Policy. In contrast, during an inflationary period, the central bank will decrease the money supply to drive up the interest rates to decrease aggregate demand — this is known as Contractionary Monetary Policy.
Figure 2. Contractionary stabilization policy, StudySmarter Originals
As you can see in Figure 2 above, contractionary policy (both fiscal and monetary) will decrease aggregate demand to get the economy into long-run equilibrium. This will decrease the price level from P1 to P2 and output from Y1 to Y2.
Direct Controls
The government using these tools (fiscal and monetary policy) to control consumer behavior is known as direct controls. Direct controls go against the laissez-faire principle of economics, where little to no government control should be exercised in an economy.
Let's take a look at the long-run consequences of Fiscal stabilization policy.
Expansionary fiscal policy is used to increase aggregate demand during a recession. To finance this policy, governments will need to borrow money and increase their current budget deficit. The government may need to borrow from the same loanable funds market that private businesses use. Since the government is borrowing more to finance an expansionary fiscal policy, there will be less money for private businesses to borrow from, due to increased interest rates, which would subsequently lower economic growth.
But wait, shouldn't expansionary fiscal policy increase economic growth? Your intuition is correct! However, the phenomenon we described above is known as crowding out. Crowding out happens when interest rates increase as a result of expansionary fiscal policy which means that the effect of increasing aggregate demand can be negatively affected - an unintended consequence of an expansionary fiscal policy.
To dive deeper click on our articles - Crowding Out and The Loanable Funds Market
The trade balance can be affected if interest rates increase with expansionary fiscal policy.
Higher interest rates in the U.S. also mean a higher rate of return for foreign investors. This will cause the demand for the dollar to increase and result in its appreciation. This dollar appreciation will drive up the price of the dollar relative to other currencies, thus, leading to U.S. goods becoming relatively more expensive compared to other countries. More expensive goods will drive down U.S. exports and drive up U.S. imports, leading to a deterioration in the trade balance. This can cause the aggregate demand to decrease in times of expansionary fiscal policy — an unintended consequence.
Trade Balance is the difference between exports and imports
Figure 3. U.S. Trade Balance, StudySmarter Originals. Source: Federal Reserve Economic Data1
Mercantilism
A country may purposely choose to depreciate its currency to lower the price of goods and increase its exports! In turn, increasing their trade balance. This practice fits an economic theory known as mercantilism: the goal of increasing exports and minimizing imports. This goal can also be achieved by trade restrictions such as tariffs and quotas.
Dive in our article - Tariffs and Quotas - to learn more!
The Budget Balance is the difference between government revenue and spending. A budget surplus is when the government's revenue is higher than its spending; a budget deficit is when a government's spending is higher than its revenue. When a government continually runs a deficit, it will be added to the government debt.
You bet we've got you covered on this one too! Check out - The Budget Balance and National Debt
If a country, say the U.S., is borrowing money to fund expansionary fiscal policies, then they need to eventually pay off this debt. How can they do this? One of two ways: increase taxes or continue to borrow to pay for their debt. Raising taxes is unpopular with many, but it is, arguably, a viable solution to pay off the debt. However, continuing to borrow to pay the U.S. debt is not a viable solution. This can lead to the U.S. defaulting on its debt — a disastrous consequence of expansionary fiscal policy.
Implicit liabilities
Implicit liabilities are spending promises that a government makes that act as a debt, such as social security and medicare. However, implicit liabilities are not included in debt statistics. To account for this, governments may be incentivized to balance their budget or run budget surpluses.
Dive in our article - Implicit Liabilities to explore further!
The central bank implements monetary policy by controlling the money supply and interest rate. Just like fiscal policy, there are long-run consequences of utilizing monetary policy that central banks need to be aware of.
The trade balance can be affected by monetary policy. The logic is the same as with fiscal policy: increased interest rates will cause the trade balance to deteriorate. The difference is that with monetary policy, interest rate manipulation is intended by the central bank.
Previously, we assumed that increased interest rates would be an unintentional consequence of expansionary fiscal policy. We attributed this to public sector borrowing crowding out private sector borrowing. With monetary policy, increased interest rates are the desired goal of the central bank. Therefore, appreciation of the dollar is inevitable with expansionary monetary policy. With expansionary monetary policy, a deterioration in the trade balance is expected. Contractionary monetary policy will improve the trade balance.
Check out - Balance of Payments Accounts article - to understand the trade balance better
Expansionary monetary policy (such as an increase in the money supply) should increase aggregate demand to assist the economy during recessions, leading to an increase in overall prices. However, in the long run, workers will demand higher wages as a result of increased prices — this will decrease the aggregate supply and shift it to the left. This is because firms' costs of production would increase due to increased wages, leading to less supply from producers. This will decrease the aggregate supply as the aggregate demand is increasing. But what does this all mean?
The price level will increase drastically as a result of increasing aggregate demand and decreasing aggregate supply. This will cause the output to stay exactly the same as before the monetary policy took place. This is an example of Monetary Neutrality — the money supply increase has no real effects on the economy. The only change taking place is the increasing price level. This phenomenon can also be applied to a contractionary monetary policy where the overall price level would go down.
Figure 4. Monetary neutrality, StudySmarter Originals
As you can see in Figure 4 above, expansionary monetary policy increased aggregate demand and decreased aggregate supply. The result is the same output at Y3 as Y1 and an increased price level at P3.
Inflation tax
The act of printing money which results in lowering its value results in what is known as 'inflation tax'.
This can happen with all inflation levels, such as disinflation, moderate inflation, and hyperinflation.
Learn more in our article - Inflation Tax!
While inflation can occur through expansionary monetary policy in the long run, it is not the only outcome. Economic growth is a potential result of expansionary monetary policy. Lowered interest rates can cause an increase in investments, leading to an increase in aggregate demand. These investments can also cause an increase in factories and machines, leading to an increase in aggregate supply. How does this differ from our previous example?
Previously, aggregate demand increased while aggregate supply decreased. Now, both will increase. This does lead to an overall increase in output, not just a change in price. We have achieved economic growth!
Figure 5. Economic growth, StudySmarter Originals
As you can see in Figure 5 above, expansionary monetary policy increased aggregate demand and aggregate supply. The result is the long-run aggregate supply shifting to the right from LRAS1 to LRAS2. This increases output from Y1 to Y2 and keeps the same price level at P1.
Directly controlling fiscal and monetary policies can have both unintended and intended consequences. It is important to recognize what these policies are meant to do, and what they can lead to.
Sources:
1. Federal Reserve Economic Data - Trade Balance: Goods and Services, Balance of Payments Basis https://fred.stlouisfed.org/series/BOPGSTB
The long-run consequences of stabilization policies are: crowding out, trade balance changes, defaulting on debt, inflation, and economic growth.
The long-run consequences of monetary policy are monetary neutrality and economic growth.
Examples of stabilization policies are fiscal and monetary policies.
Examples of long-run consequences of fiscal policies are: crowding out, trade balance deterioration, defaulting on government debt
Examples of long-run consequences of monetary policies are: effects on the trade balance, monetary neutrality and economic growth.
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