CHAPTER 15  
 Stabilization Policy

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UNIT FIVE

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       I.        Economic Fluctuations—The Historical Record

                A.        Historically, the United States has experienced substantial swings in real output.

                B.        Prior to the Second World War, year‑to‑year changes in real GDP of 5 percent to 10 percent were experienced on several occasions.

                C.        During the last five decades, the fluctuations of real output have been more moderate.

        II.        Promoting Economic Stability—Activist and Nonactivist Views

                A.        Goals of Stabilization Policy

                        1.        Stable growth of real GDP.

                        2.        Relatively stable level of prices.

                        3.        High level of employment (low unemployment).

                B.        Activists' Views of Stabilization Policy

                        1.         Self corrective mechanism works slowly or not at all.

                        2.                Policy-makers will be able to alter macro-policy, injecting stimulus to help pull the economy out of recession and restraint to help control inflation.

                        3.                According to the activist s view, policy-makers are more likely to keep the economy on track when they are free to apply stimulus or restraint based on forecasting devices and current economic indicators.

                C.        Nonactivists' Views of Stabilization Policy

                        1.        Self-corrective mechanism of markets works pretty well.

                        2.                Greater stability would result if stable, predictable policies based on predetermined rules were followed.

                        3.                Nonactivists argue that the problems of proper timing and political considerations undermine the effectiveness of discretionary macro policy as a stabilization tool.

        III.   The Application of Discretionary Stabilization Policy

                A.        Index of Leading Indicators

                        1.                Composite statistic based on 10 key variables that generally turn down prior to a recession and turn up before the beginning of a business expansion.

                        2.                Can forecast future and help policy makers, but it is an imperfect forecasting devise.

                B.         Forecasting Models

                C.        Market Signals and Discretionary Monetary Policy    

        IV. Practical Problems With Discretionary Macro Policy

                A.        Lags and the Problem of Timing

                        1.                After a change in policy has been undertaken, there will be a time lag before it exerts a major impact. This means the policy makers need to forecast economic conditions several months in the future in order to institute policy changes effectively.

                B.         Politics and Timing of Policy Changes

                        1.                Policy changes may be driven by political considerations rather than stablization.

        V.    There Are Two Major Theories About How Expectations Are Formed

                A.        Adaptive Expectations: individuals form their expectations about the future on the basis of data from the recent past.

                B.        Rational‑expectations: Assumes that people use all pertinent information, including data on the conduct of current policy, in forming their expectations about the future.

        VI.   How Macro Policy Works: The Implications of Adaptive and Rational Expectations

                A.        With adaptive expectations, an unanticipated shift to a more expansionary policy will temporarily stimulate output and employment.

                B.        With rational expectations, expansionary policy will not generate a systematic change in output.

                C.        Both expectations theories indicate that sustained expansionary policies will lead to inflation without permanently increasing output and employment.

        VII. Emerging Consensus View

                A.        Monetary policy consistent with approximate price stability is the key ingredient of effective stabilization policy.

                B.         Avoid wide policy swings.

                C.    Responding to minor economic ups and downs is a mistake.

        VIII. The Recent Stability of the U.S. Economy

                A.    The objectives of stabilization policy have been less ambitious in recent years. Rather than trying to control output and employment, the focus has shifted to the achievement of price stability.

                B.        Paradoxically, movement toward price stability has led to a rather dramatic reduction in economic fluctuations.