The Stabilization Function of Government

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The Stabilization Function of Government:
(“Economics” – Chapters 6 and 7)
Recall… Government Intervention in markets and the economy is most often justified by arguing for government to serve one of the three following functions:

1. Allocation Function(discussed in previous topic)

2. Distribution Function(discussed in previous topic)

3. Stabilization Function – attempts by government to minimize fluctuations in overall macroeconomic activity

  • Business Cycle – the periodic but irregular fluctuation in overall macroeconomic activity which occurs over time, measured by changes in “Real GDP” (and other measures of macroeconomic activity)

GDP Growth “trend line”

Real GDP





one business cycle





Phases of the business cycle: recovery, peak, recession, trough, recovery, peak, recession, trough…

  • Recession – a period of time during which an economy is contracting, commonly defined as six or more consecutive months of declining real GDP

  • Trough – the point in time at which an economy stops contracting at the end of a recession (i.e., economic activity reaches a minimum)

  • Expansion – a period of time during which an economy is growing or recovering (i.e., economic activity is increasing, often reflected by a positive GDP growth rate)

  • Peak – the point in time at which an economy stops growing at the end of an expansion (i.e., economic activity reaches a maximum)

Two Key Facts about Economic Fluctuations:

  1. Economic Fluctuations are Irregular and Unpredictable

  • Recessions do not come at “regular intervals” and the timing of a peak or trough is hard to predict



% decrease in Real GDP

Length of Recession (months)

Length of Subsequent Expansion (months)

Nov 1948

Oct 1949




July 1953

May 1954




Aug 1957

April 1958




April 1960

Feb 1961




Dec 1969

Nov 1970




Nov 1973

Mar 1975




Jan 1980

July 1980




July 1981

Nov 1982




July 1990

Mar 1991




Mar 2001

Nov 2001




Dec 2007

June 2009



  1. Many macroeconomic variables “move together”

  • during an economic downturn, we will likely realize decreases in consumer income and spending, decreases in business profits and investments, and an increase in the unemployment rate

  • Argument for government intervention: since economic downturns are often disruptive to businesses and households, society would likely prefer a “smoother” rate of growth, with minimal fluctuations over time

    • Evidence suggests that, all else equal, households prefer smooth paths of consumption (e.g., if you get paid $4,000 on the first of every month, you are not likely to spend the entire paycheck on the first day and nothing during the rest of the month)

  • Notion that government should attempt to influence macroeconomic activity (GDP growth rate, inflation rate, unemployment rate) is a recent idea.

  • Two broad types of government policies which can stabilize macroeconomic activity:

  1. Fiscal Policy – Government policies related to spending and revenue generation.

  2. Monetary Policy – Government policies which determine the nation’s Money Supply.

John Maynard Keynes:

  • “The General Theory of Employment, Interest and Money” (1936) [written against the backdrop of the Great Depression] => essentially an assault on “traditional macroeconomic thought” (previous argument was for direct control of the macroeconomy)

  • central argument of “The General Theory…”: markets are volatile and might not result in “full employment”

  • total output might not equal its maximum level => possible equilibria in which there is insufficient spending to support a normal level of production

  • Outcomes during Great Depression:

    • people don’t have jobs/incomes

    • without income people don’t buy output from firms

    • firms can’t make profits, so they shutdown and layoff workers

    • stable state with low resource use and low output

  • low output equilibria caused by too little spending => recall, from our discussion of GDP that:

  • thus, a very low value of can bring down

  • solution: replace missing private spending with government spending (i.e., offset the low value of with a higher value of ) => deficit spending as an economic stimulus during downturns [a budget deficit occurs when government spending exceeds revenues]

  • corollary: government should cut back spending and run a surplus during an expansion (this has often been overlooked) [a budget surplus occurs when government revenues exceed spending]

  • Key implication: Fiscal Policy can indirectly stabilize macroeconomic activity (“spending against the wind”)

Using Fiscal Policy to Minimize Fluctuations:
Implementing Fiscal Policy is a complicated, multifaceted process => in the U.S., Fiscal Policy is determined by decisions jointly made by the House, Senate, and President (i.e., the Legislative and Executive branches)

  • Expansionary Fiscal Policy – increases in government spending or decreases in taxes with the aim of stimulating overall economic activity

  • too much stimulus can ultimately lead to excessive inflation (if the economy is at or near “full employment”)

  • Contractionary Fiscal Policy – decreases in government spending or increases in taxes with the aim of dampening overall economic activity

Crowding Out – decreases in private spending that occur following increases in government spending

  • as is increased, does remain constant or decrease? => a decrease in reveals “crowding out”

  • If a significant amount of crowding out occurs, then the effectiveness of stimulative Fiscal Policy will be reduced, since the government spending does not create any new economic activity, but rather replaces private economic activity with government economic activity (in a likely inefficient way)

  • However, if instead productive resources are not fully employed, then government spending will use otherwise idle resources and thus will generate new economic activity => could lead to a significant short term increase in overall economic activity as desired

Relation between the Money Supply, Aggregate Output, and the Price Level…

  • Money Supply – the amount of money in circulation in an economy (denoted )

  • Equation of Exchange:

  • an identity which relates the money supply, velocity of money, overall price level, and aggregate level of output to each other

  • velocity of money (denoted ) – the number of times that a typical dollar is used in market transactions in a single year

  • overall price level (denoted ) – the “average” of all the prices of goods/services traded

  • aggregate level of output (denoted ) – a measure of the real quantity of goods/services produced

  • let denote GDP, and suppose we have $24 billion of GDP

    • if we have $8 billion in circulation, then each dollar must be spent on average 3 times => if $8 billion, then 3 => more generally

    • if we produce 2 billion units of real output, then the average price of each unit must be $12 => if 2 billion, then $12 => more generally

  • thus, and => =>

  • fixing , an increase in must ultimately result (both in the short term and long term) in an increase in and/or

Using Monetary Policy to Minimize Fluctuations:

  • In the decades following WW-II “Monetarismemerged as an alternative to “Keynesianism” => Monetarism argued that economic fluctuations depended more on Monetary Policy than on Fiscal Policy

  • Primary advocate of Monetarism was Milton Friedman (1912-2006; Nobel Prize in 1976)

    • “A Monetary History of the United States, 1867-1960” written by Friedman and Anna Schwartz (published in 1963), provided strong evidence to support a claim that the money supply has a direct impact on short run levels of income, employment, and inflation

  • Overview of ideas of Monetarists: if, in the short term, is below its maximum possible level, then increasing can increase

    • When the money supply is increased, money is more readily available, particularly in the loanable funds market

    • loanable funds market – the collection of all markets in which lenders and borrowers interact (e.g., mortgage markets, auto loan markets, consumer credit markets, business loan markets)

  • when loanable funds are more readily available, interest rates decrease => businesses become more inclined to build new factories, expand production, and hire workers, while households become more inclined to make major purchases of goods/services

  • starting at a point where is below its maximum possible level, increasing the money supply can lead to a real increase in economic activity (i.e., in )

Expansionary Monetary Policy – an increase in the money supply which provides a short term stimulus to the macro-economy, resulting in higher levels of output, employment, and incomes
Contractionary Monetary Policy – a decrease in the money supply which dampens overall economic activity, resulting in lower levels of output, employment, and incomes in the short term (but greater stability in the long term)
Q: Who controls the Money Supply? A: The Central Bank
Central Bank – entity which has the ability to alter the money supply of an economy

  • Primary task is to control the nation’s money supply.

  • U.S.: Federal Reserve (created in 1913)

  • U.K.: Bank of England (created in 1694)

  • Federal Reserve is an independent central bank, in that its actions are not directly dictated by the legislative or executive branch (although the Federal Reserve is subject to oversight by Congress)

  • experience in the U.S. and other countries suggests that independent central banks are better at promoting stable economic growth and maintaining the value of a country’s currency => an independent central bank is less vulnerable to short term political pressures

So, how does the central bank go about altering the money supply? They could literally go about “printing money,” but this is not in fact the primary way that the money supply is altered.

Three policy tools of the Fed to alter the money supply:

  1. Open-market Operations – buying and selling of U.S. Treasury debt securities to and from the public

  • buying bonds puts more money in circulation (increases money supply); selling bonds takes money out of circulation (decreases money supply)

Fractional Reserve Banking System – a system in which at any point in time a commercial bank is only required to retain a portion of the money it has accepted as deposits

  1. Setting of Reserve Requirements – minimum restrictions on the amount of money that a bank must keep on hand at any point in time, in the form of either cash in its vault or deposits with the central bank

  • system essentially allows banks to “create money” by loaning out a portion of their deposits => e.g., bank holding deposits of $500,000,000 can: loan out $450,000,000 if the reserve requirement is 10% versus loan out $465,000,000 if the reserve requirement is 7% => lowering the reserve requirement increases the money supply

  1. Setting of Discount Rate – setting the interest rate that the Fed charges banks on short-term loans

  • banks often meet the reserve requirement by borrowing funds from the central bank or other banks on a short term basis

  • lowering the discount rate reduces the cost for a bank of taking out such short term loans (reduces the cost of loaning out additional money), thereby increasing the money supply

So, why not always increase the money supply in order to stimulate economic activity?
Monetarist’s answer: In the long run, changes in the money supply have no impact on the overall level of real economic activity, but rather only have an impact on price

  • in the long run, an efficient market economy will tend toward a situation in which all resources are being used and society is producing close to its maximum level of output (i.e., is at its maximum value)

  • recalling , the only possible consequence of an increase in is ultimately a corresponding increase in => an increase in the money supply will not alter total output in the long run but will only increase prices in the long run

  • Milton Friedman: “Inflation is always and everywhere a monetary phenomenon.”

  • Inflation and Money Supply in Peru (1979-1991) => annual inflation rates of 3,398% in 1989 and 7,482% in 1990 => Note the parallel with the money supply!

Timing Difficulties of Stabilization Policies (both Fiscal Policy and Monetary Policy):

    1. Information and Recognition Lags – the time that policymakers must wait in order to collect and process economic data and confirm that a stabilization policy is needed

      • data on macroeconomic outcomes is not available immediately (most measures are available three months after the fact)

      • policymakers must wait for economic data to be collected, processed, and reported

      • further, a small change in an economic outcome (e.g., a slight decline in GDP or slight increase in unemployment) might be the start of a recession…or might not

      • we are often several months into a downturn before we even know it

    2. Decision Lag – the time that it takes a policymaker to decide upon the specific stabilization policies to enact

      • It may take Congress several months to debate and pass a “stimulus bill”

    3. Implementation Lag – the time that it takes for the enacted policy to have an impact on macroeconomic outcomes

      • it often takes about 12 to 18 months for an enacted policy to have an actual impact on the economy

By the time a stabilization policy begins to stimulate the economy, the economy may already naturally be in a recovery => policy may ultimately make fluctuations more severe, by overstimulating an economy already in recovery

  • most all economists agree that both fiscal policy and monetary policy have an impact on macroeconomic outcomes in both the short run and long run

  • two of the statements with which there is “general agreement among economists”…

  • “Fiscal Policy has a significant stimulative impact on a less than fully employed economy.” [88.6% agreement]

  • “Inflation is caused primarily by too much growth in the money supply.” [75.0% agreement]

  • thus, most all economists would agree that either Fiscal Policy or Monetary policy could potentially be used to stabilize macroeconomic activity over time (or, if used poorly, could have an undesirable impact on macroeconomic outcomes over time)

  • the “disagreement” arises with regard to views on which type of policy:

    • has a more significant impact?

    • is easier to time?

    • has fewer potential long term negative consequences (e.g., “inefficient allocation of resources” versus or “possibility of high inflation rates”)?

  • in closing, another statement with which there is “general agreement among economists”…

  • “Management of the business cycle should be left to the Federal Reserve; activist fiscal policy should be avoided.” [70.4% agreement]

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