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Stabilization Policy

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Stabilization Policy

How would you assist injured people at the hospital using the same toolkit? Is it even possible? And better yet, do you think that would really work? Well, that's the issue the government runs into when trying to help the economy. The government adopts policies aimed at fostering a successful economy that directly benefit all of its citizens, which is a difficult challenge. An economic policy that helps one group of people could harm another. Increasing interest rates to bring inflation down makes it hard for firms to raise money to grow and hire more people; the rate of unemployment may rise. Low rates, though, can generate inflation as consumption rises and then many people find salary boosts worthless as prices rise. It's all a balancing act. Want to find out how it's done? Continue on!

Stabilization Policy Definition

The modification of economic policies by governments to support economic development without substantial swings in joblessness, inflation, and interest rates is referred to as stabilization policy.

Stabilization policy is the modification of economic policies by governments to support economic growth and development.

Because the economy fluctuates, governments use fiscal or monetary policies to make sure that the economy is doing well. A stabilization policy is a solution used by governments to mitigate unpredictable price fluctuations that harm an economy's GDP. It is frequently employed as an economic and political tool to maintain the economy's well-being.

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.

Expansionary fiscal policy is when the federal government moves to lower taxes or increase spending to boost the economy.

Contractionary fiscal 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.

Expansionary monetary policy is when the Federal Reserve moves to lower interest rates to boost the economy.

Contractionary monetary policy is when the Federal Reserve increases interest rates to slow the economy and reduce inflation.

To keep the economy thriving, the government pursues three policy objectives: price stability, total employment, and economic expansion. The government has other aims to maintain good economic policy besides these aspirations. Low or steady interest rates, a stable budget (or at minimum a budget with a lower deficit than the preceding budget), and a reasonable balance of trade with other nations are examples of this.

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.

Liquidity is defined as the ease with which an asset, or security, can be converted into cash without impacting its price.

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.

Economic Stabilization Policies U.S. Capitol Building StudySmarterFigure 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.

It should be emphasized, though, that in developing economies, monetary policy must support and foster economic growth in both the manufacturing and farming sectors, in addition to ensuring balance at full employment or potential output levels.

Economic Stabilization Policies - Key takeaways

  • Stabilization policy is the modification of economic policies by governments and central banks to support economic development.
  • Expansionary fiscal policy is when the government moves to lower tax rates or boost government expenditure. Contractionary fiscal policy is when the government increases tax rates or reduces government expenditure.
  • Expansionary monetary policy is when the Federal Reserve moves to lower interest rates. Contractionary monetary policy is when the Federal Reserve increases interest rates.
  • The business cycle is important when it comes to the stabilization of the economy.
  • Governments and central banks use monetary or fiscal policies to ensure that the economy is doing well.

Frequently Asked Questions about Stabilization Policy

Stabilization policy is the modification of economic policies by governments to support economic development.

Monetary and fiscal.

Price stability, total employment, and economic expansion.

Interest rates, control of credit/loans, requirements for cash reserves, and participating in the open market. 

They're used to attempt to reduce disruptions to economic development and the stability of prices.

Final Stabilization Policy Quiz

Question

What is a demand-side policy?

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demand-side policy is an economic policy focused on increasing or decreasing aggregate demand to influence unemployment, real output and the price level in the economy.

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What are the two types of demand-side policies?

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Types of demand side policies include fiscal policy and monetary policy.

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What are the four components of aggregate demand?

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There are four components of aggregate demand: Consumption spending (C), gross private domestic investment (IG), government expenditures (G), and net exports (XN). 

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Give an example how a tax cut injects money in the economy, leading to a growth in GDP.

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A tax cut leaves businesses and consumers with extra cash, which they are encouraged to spend to stimulate the economy during a recession (two or more consecutive quarters - three-month periods - of reduced GDP). By increasing spending, the government has increased aggregate demand and can reduce unemployment by stimulating the economy.

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What are demand-side policies sometimes called?

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Keynesian economics.

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What did John Maynard Keynes say about using fiscal policies to stimulate aggregate demand?

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John Maynard Keynes argued that the government should use fiscal policies to lower unemployment numbers and stimulate total spending in the economy (aggregate demand). Keynes theory suggests that any change in the components of aggregate demand would also change the GDP. 

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Explain monetary policy.

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Monetary policies are also known as demand-side policies. Monetary policies are designed by the Federal Reserve, the United States's central bank. Monetary policy directly impacts the interest rate, which then influences the amount of investment and consumer spending in the economy, both essential components of aggregate demand.

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What happens if there is a lower interest rate in the economy?

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Suppose monetary policies favor low-interest rates. In that case, there will be more investment spending as it is cheap to borrow. Therefore, this will lead to an increase in aggregate demand.

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What happens to the economy when there is an increase in government spending?

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Total output produced and the price level increases.

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Why monetary policy is demand side policy?


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Monetary policy is a demand side policy because it impacts the level of investment spending and consumer spending, which are some of the main components of aggregate demand.

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What is an example of a demand-side policy?


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The government investing $20 billion in building infrastructure across the country.

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What are the advantages of demand-side policies?


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A major benefit of demand-side policies is speed. 

A second significant benefit of demand-side policies is the ability to direct government spending where needed more. 

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What are the disadvantages of demand-side policies?


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A downside of demand-side policies is inflation. Rapid government spending may be too effective and result in rising prices. 

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What's the difference between supply-side and demand-side policies?

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When it comes to supply-side vs. demand-side policies, the main difference between the two is that the supply side aims to increase the long-run aggregate supply. In contrast, demand-side policies aim to increase aggregate demand in the short run. 

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Name two types of supply-side policies.

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Lower taxes, lower interest rates, and better regulations that encourage firms to invest in their productive capacities and efficiencies and thus increase the long-run aggregate supply.

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How would you define stabilization policies?

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Stabilization Policies are a macroeconomic tool used by governments and central banks to drive the economy towards economic growth. This is achieved by ensuring that macroeconomic variables such as aggregate demand and supply, employment, inflation, and price levels are at adequate levels. 

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What are the 3 goals governments and central banks looking to achieve through the implementation of stabilization policies?

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  1. Stabilized price levels
  2. Optimal employment
  3. Economic growth 


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What are the two types of stabilization policies?

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Fiscal and Monetary 

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Fiscal policies are enacted by the government through modifying government expenditure and taxation.


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False

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Monetary policies are enacted by the central bank of the economy by influencing the money supply and interest rates.


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True

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The implementation of  --------------------- fiscal policy allows for the negative output gap to be closed.

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expansionary 

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A negative output gap is a result of actual output being ----------- than potential output.


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less

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The implementation of --------------------- fiscal policy allows for the positive output gap to be closed.


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contractionary 

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A positive output gap is a result of actual output being -------------- than potential output.


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greater

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The implementation of the expansionary monetary policy allows for the money supply and credit to ----------------- in the economy.


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increase

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The implementation of the contractionary monetary policy allows for money supply and credit to ------------------- in the economy and as a result curb inflation. 


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decrease 

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The fiscal instruments that are used by the government to implement expansionary and contractionary fiscal policies are:

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  • Taxes
  • Government spending
  • Government Transfers

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The monetary instruments that are used by the central bank to implement expansionary and contractionary monetary policies are: 



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  • Open market operations
  • Cash reserve requirements
  • Manipulating the bank rate


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What are the resulting effects of the implementation of the instruments for an expansionary fiscal policy?



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  • an increase in aggregate demand, consumer disposable income, employment and investment.


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What are the resulting effects of the implementation of the instruments for a contractionary monetary policy?

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  •  decrease in the money supply and credit in the economy which will then stimulate a decrease in aggregate demand, consumer disposable income, and investment and curb inflation.

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How would you describe macroeconomic stability?

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Macroeconomic stability occurs when aggregate demand (AD) and aggregate supply (AS) are in balance, which helps to determine the equilibrium price level at which goods and services are bought and sold.

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Define aggregate demand

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Aggregate Demand is the total value of goods and services demanded at any given price level.

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Define aggregate supply

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Aggregate Supply is the total value of all goods and services produced at any given price level.

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Define real Gross Domestic Product

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Real Gross Domestic Product is the total value of all final goods and services produced or consumed, adjusted for inflation.

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Which of the following would lead to an increase in aggregate demand?

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Higher taxes

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Which of the following would lead to a decline in demand?

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Weak or negative job growth

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What is the main reason macroeconomic stability is important for economic growth?

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Certainty

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Demand-side fiscal policy uses what to affect demand?

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Government spending on goods and services and government transfers

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Supply-side fiscal policy uses what to affect supply?

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Taxes and regulation

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The Federal Reserve's setting of interest rates to affect the economy is known as _____ _____.

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Monetary policy

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If the Federal Reserve wants to stimulate demand, it would _____ interest rates by _____ Treasury securities.

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raise/buying

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Unemployment insurance and food stamps are known as _____ _____.

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automatic stabilizers

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Which of the following is not a macroeconomic stability indicator?

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Real GDP

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What is considered to be the most familiar economic statistic known to students?

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Job growth

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A low unemployment rate is a sign of a _____ economy.

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strong

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If interest rates rise, people will be _____ likely to borrow and spend.

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less

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Trying to reduce regulations on businesses is an example of what?

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Supply-side fiscal policy

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If inflation is accelerating, what will the Fed do to restore macroeconomic stability?

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Raise interest rates

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Stabilizing monetary policy is a tool used by the government by influencing the money supply to help the economy reach a stable state.

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False

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List the main functions of a central bank.

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The central bank is a financial institution of an economy that manages the money supply and oversees the commercial banking system 

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