21.3 Using Policy to Stabilize the Economy

21.3 a. The Case for Active Stabilization Policy

According to traditional views of stabilization policy, monetary and fiscal policy can moderate the business cycle by offsetting changes in aggregate demand by consumers and businesses that would otherwise cause inflationary pressures or weaker economic activity [20].

A formal inflation-targeting regime allows an easing of monetary policy in response to weaker economic activity to the extent that there is an associated lessening of inflationary pressures. Similarly, policy might respond to asset price movements to the extent they are expected to influence future inflation. Indeed, to the extent that inflation targets are viewed symmetrically, a central bank would alter policy in response to both inflationary pressures and to disinflationary or deflationary pressures [20].

Example: In the late 1950s and early 1960s, belief in the efficacy of stabilization policy to moderate business cycle fluctuations was widespread among policymakers and academics and resulted in a number of attempts to use fiscal policy to increase or slow the pace of economic activity [20].

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^{Should Policymakers Try to Stabilize the Economy? [21]}

21.3 b. The Case against Active Stabilization Policy

We can examine long-run economic growth using the AD/AS model, but the factors that determine the speed of this long-term economic growth rate do not appear directly in the AD/AS diagram. Cyclical unemployment is relatively large in the AD/AS framework when the equilibrium is substantially below potential GDP and relatively small when the equilibrium is near potential GDP. The natural rate of unemployment—as determined by the labor market institutions of the economy—is built into potential GDP, but does not otherwise appear in an AD/AS diagram. Pressures for inflation to rise or fall are shown in the AD/AS framework when the movement from one equilibrium to another causes the price level to rise or to fall [17].

Example: When an AD/AS diagram shows an equilibrium level of real GDP substantially below potential GDP it indicates a recession. On the other hand, in years of resurgent economic growth the equilibrium will typically be close to potential GDP [17].

^{Long-Run Growth, Recession and Inflation [18]}