What is Stabilization Policy

A stabilization policy is a macroeconomic strategy enacted by governments and central banks to keep economic growth stable, along with price levels and unemployment. Ongoing stabilization policy includes monitoring the business cycle and adjusting benchmark interest rates to control aggregate demand in the economy. The goal is to avoid erratic changes in total output as measured by gross domestic product (GDP), and large changes in inflation. Stabilization of these factors generally leads to moderate changes in the employment rate as well.

BREAKING DOWN Stabilization Policy

Stabilization policies are fiscally oriented and designed to reduce fluctuations in certain areas of the economy (e.g., inflation and unemployment) while aiming to maximize associated national income levels. Fluctuations can be controlled through various mechanisms, including policies that stimulate demand to counter high levels of unemployment and those that suppress demand to counter rising inflation.

Stabilization Policy and Economic Recovery

Stabilization policies are also used to help an economy recover from a specific economic crisis or shock, such as sovereign debt defaults or a stock market crash. In these instances, stabilization policies may come from governments directly through overt legislation and securities reforms or from international banking groups such as the World Bank.

Stabilization Policy and Keynesian Economics

Noted economist John Maynard Keynes theorized that when individuals within an economy do not have the buying power to purchase the goods or services being produced, prices fall as a means to entice customers. As prices fall, businesses could experience significant losses, resulting in an increase in corporate bankruptcies. Subsequently, unemployment rates increase, which further reduces the buying power in the consumer market.  This loss of buying power thus lowers prices again.

This process was considered cyclical in nature, and to stop the cycle, fiscal policy changes would be required. Keynes suggested that through policy creation, a government could manipulate aggregate demand to correct the trend.

Top economists believe that as economies become more complex and advanced, maintaining a steady price level and pace of growth are essential for long-term prosperity. When any of the aforementioned variables becomes too volatile, there are unforeseen consequences to the broad economy that keep markets from functioning at their optimal level of efficiency. Most modern economies employ stabilization policies, with much of the work being done by central banking authorities like the U.S. Federal Reserve Board. Stabilization policy is largely credited with the moderate but positive rates of GDP growth seen in the United States since the early 1980s.