What Is Stabilization Policy?

Stabilization policy is a strategy enacted by a government or its central bank that is aimed at maintaining a healthy level of economic growth and minimal price changes. Sustaining a stabilization policy requires monitoring the business cycle and adjusting fiscal policy and monetary policy as needed to control abrupt changes in demand or supply.

In the language of business news, a stabilization policy is designed to prevent the economy from excessive "over-heating" or "slowing down."

Key Takeaways

  • Stabilization policy seeks to keep an economy on an even keel by increasing or decreasing interest rates as needed.
  • Interest rates are raised to discourage borrowing to spend and lowered to boost borrowing to spend.
  • Fiscal policy can also be used by increasing or decreasing government spending and taxes to affect aggregate demand.
  • The intended 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 U.S. economy has been in a recession for about one in every seven months since the end of World War II. This cycle is seen as inevitable, but stabilization policy seeks to soften the blow and prevent widespread unemployment.

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

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. The responses may include emergency actions and reform legislation.

The Roots of Stabilization Policy

Pioneering economist John Maynard Keynes argued that an economy can experience a sharp and sustained period of stagnation without a any kind of natural or automatic rebound or correction. Previous economists had observed that economies grow and contract in a cyclical pattern, with occasional downturns followed by a recovery and return to growth. Keynes disputed their theories that a process of economy recovery should normally be expected after a recession. He argued that the fear and uncertainty that consumers, investors, and businesses face could induce a prolonged period of reduced consumer spending, sluggish business investment, and elevated unemployment which would all reinforce one another in a vicious circle.

In the U.S., the Federal Reserve is tasked with raising or lowering interest rates in order to keep demand for goods and services on an even keel.

To stop the cycle, Keynes argued, requires changes in policy in order to manipulate aggregate demand. He, and the Keynesian economists who followed him, also argued the reverse policy could be used to fight off 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 in use today to increase or decrease demand are to lower or raise interest rates for borrowing or to increase of decrease government spending. These are known as monetary policy and fiscal policy, respectively.

The Future of Stabilization Policy

Most modern economies employ stabilization policies, with much of the work being done by central banking authorities such as the U.S. Federal Reserve Board. Stabilization policy is widely credited with the moderate but positive rates of GDP growth seen in the U.S. since the early 1980s. It involves using expansionary monetary and fiscal policy during recessions and contractionary policy during periods of excessive optimism or rising inflation. This means lowering interest rates, cutting taxes, and increasing deficit spending during economic downturns and raising interest rates, rising taxes, and reducing government deficit spending during better times.

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