Stabilizing the Economy

Using Policy to Stabilize the Economy

We have seen how monetary Opens in new window and fiscal policy Opens in new window can affect the economy’s aggregate demand for goods and services. These theoretical insights raise some important policy questions:

Should policymakers use these instruments to control aggregate demand and stabilize the economy?

If so, when? If not, why not?

The Case for Active Stabilization Policy

We begin this entry with the question: When the president and Congress raise taxes, how should the Federal Reserve respond?

The level of taxation is one determinant of the position of the aggregate-demand curve.

When the government raises taxes, aggregate demand will fall, depressing production and employment in the short run. If the Federal Reserve Opens in new window wants to prevent this adverse effect of the fiscal policy, it can expand aggregate demand by increasing the money supply.

A monetary expansion Opens in new window would reduce interest rates, stimulate investment spending, and expand aggregate demand. If monetary policy is set appropriately, the combined changes in monetary and fiscal policy could leave the aggregate demand for goods and services unaffected.

This analysis is exactly the sort followed by members of the Federal Open Market Committee Opens in new window. They know that monetary policy Opens in new window is an important determinant of aggregate demand Opens in new window. They also know that there are other important determinants as well, including fiscal policy Opens in new window set by the president and Congress. As a result, the FOMC Opens in new window watches the debates over fiscal policy with a keen eye.

This response of monetary policy to the change in fiscal policy is an example of a more general phenomenon:

The use of policy instruments to stabilize aggregate demand and, as a result, production and employment.

Economic stabilization has been an explicit goal of U.S. policy since the Employment Act of 1946 Opens in new window.

This act states that “it is the continuing policy and responsibility of the federal government to … promote full employment and production.” In essence, the government has chosen to hold itself accountable for short-run macroeconomic performance.

The Employment Act has two implications. The first, more modest, implication is that the government should avoid being a cause of economic fluctuations.

Thus, most economists advise against large and sudden changes in monetary and fiscal policy, for such changes are likely to cause fluctuations in aggregate demand. Moreover, when large changes do occur, it is important that monetary and fiscal policymakers be aware of and respond to each others’ actions.

The second, more ambitious, implication of the Employment Act is that the government should respond to changes in the private economy to stabilize aggregate demand.

The act was passed not long after the publication of Keynes’s The General Theory of Employment, Interest, and Money Opens in new window which has been one of the most influential books ever written about economics. In it, Keynes emphasized the key role of aggregate demand in explaining short-run economic fluctuations.

The Case Against Active Stabilization Policy

Some economists argue that the government should avoid active use of monetary and fiscal policy to try to stabilize the economy. They claim that these policy instruments should be set to achieve long-run goals, such as rapid economic growth and low inflation, and that the economy should be left to deal with short-run fluctuations on its own. These economists may admit that monetary and fiscal policy can stabilize the economy in theory, but they doubt whether it can do so in practice.

The main argument against active monetary and fiscal policy is that these policies affect the economy with a long lag. As we have seen, monetary policy works by changing interest rates, which in turn influence investment spending. But many firms make investment plans far in advance. Thus, most economists believe that it takes at least 6 months for changes in monetary policy to have much effect on output and employment. Moreover, once these effects occur, they can last for several years.

Critics of stabilization policy argue that because of this lag, the Fed should not try to fine-tune the economy. They claim that the Fed often reacts too late to changing economic conditions and, as a result, ends up being a cause of rather than a cure for economic fluctuations. These critics advocate a passive monetary policy, such as slow and steady growth in the money supply.

Fiscal policy also works with a lag, but unlike the lag in monetary policy, the lag in fiscal policy is largely attributable to the political process.

In the United States, most changes in government spending and taxes must go through congressional committees in both the House and the Senate, be passed by both legislative bodies, and then be signed by the president.

Completing this process can take months or, in some cases, years. By the time the change in fiscal policy is passed and ready to implement, the condition of the economy may have changed.

These lags in monetary and fiscal policy are a problem in part because economic forecasting is so imprecise. If forecasters could accurately predict the condition of the economy a year in advance, then monetary and fiscal policymakers could look ahead when making policy decisions.

In this case, policymakers could stabilize the economy despite the lags they face. In practice, however, major recessions and depressions arrive without much advance warning. The best that policymakers can do is to respond to economic changes as they occur.

Automatic Stabilizers

All economists—both advocates and critics of stabilization policy—agree that the lags in implementation reduce the efficacy of policy as a tool for short-run stabilization.

The economy would be more stable, therefore, if policymakers could find a way to avoid some of these lags. In fact, they have.

Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action.

The most important automatic stabilizer is the tax system.

When the economy goes into a recession, the amount of taxes collected by the government falls automatically because almost all taxes are closely tied to economic activity.

  • The personal income tax depends on households’ incomes.
  • The payroll tax depends on workers’ earnings, and
  • The corporate income tax depends on firms’ profits.

Because incomes, earnings, and profits all fall in a recession, the government’s tax revenue falls as well. This automatic tax cut stimulates aggregate demand and, thereby, reduces the magnitude of economic fluctuations.

Some government spending also acts as an automatic stabilizer. In particular, when the economy goes into a recession and workers are laid off, more people apply for unemployment insurance benefits, welfare benefits, and other forms of income support.

This automatic increase in government spending stimulates aggregate demand at exactly the time when aggregate demand is insufficient to maintain full employment. Indeed, when the unemployment insurance system Opens in new window was first enacted in the 1930s, economists who advocated this policy did so in part because of its power as an automatic stabilizer.

The automatic stabilizers in the U.S. economy are not sufficiently strong to prevent recessions completely. Nonetheless, without these automatic stabilizers, output and employment would probably be more volatile than they are.

For this reason, many economists oppose a constitutional amendment that would require the federal government always to run a balanced budget, government spending rises, and the government’s budget moves toward deficit. If the government faced a strict balanced-budget rule, it would be forced to look for ways to raise taxes or cut spending in a recession. In other words, a strict balanced-budget rule would eliminate the automatic stabilizers inherent in our current system of taxes and government spending.