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 benchmark interest rates as needed to control abrupt changes in demand.

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

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.

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.
  • The intended result is an economy that is cushioned from the effects of wild swings in demand.

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 noted that an economy grows and contracts in a cyclical pattern. When people lack the means to buy the goods or services being produced, prices are reduced to entice customers. As prices fall, some businesses experience significant losses. Corporate bankruptcies increase, and job losses mount. That further reduces the buying power in the consumer market. Prices can only go lower again.

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 fiscal policy such as the manipulation of aggregate demand. In Keynesian theory, demand is stimulated to counter high levels of unemployment and it is suppressed to counter rising inflation. The main tool available to increase or decrease demand is to lower or raise interest rates for borrowing.

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 largely credited with the moderate but positive rates of GDP growth seen in the U.S. since the early 1980s.

The Future of Stabilization Policy

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.