ECONOMIC STABILIZATION POLICIES

Need For Controlling Trade Cycle

Business cycles, especially the violent fluctuations in economic activities, cause not only harm to business community, but also misery to the normal people.

Violent fluctuations in economic activities leads to unemployment, and poverty.

Till great depression in 1930s,there was an economic belief that ‘invisible market forces’ would automatically maintain the balance in the economy.

The major stabilization problem in the developing countries is the problem of controlling prices and in the developed countries , preventing growth rates from sliding further down.

Stabilization broadly means preventing extreme ups and downs in the economy.

Major objectives

Preventing excessive and prolonged economic fluctuations.

Creating conditions for efficient utilization of labour and other productive resources.

Encouraging free competitive enterprise with minimum interference with the functioning of the market economy.

Promotion of employment.

The two important widely used economic policies are

Fiscal policyMonetary policy Fiscal policy uses government taxation,

spending and borrowing to influence the economy. Monetary policy consists of adjusting the money supply (the amount of money in circulation) and setting the prime rate (the interest rate that banks pay to each other on loans).

Fiscal policy

Refers to the government policy of changing taxation and public expenditure programs.

Basic instruments usedTaxation is a measure of transferring funds

from private to the public. Taxation reduces private disposable income,

thereby, the private expenditure.Public expenditure increases the flow of funds

in the economy.The public expenditure ,increases the private

income and thereby , the private expenditure.

How it relates with GNP

Public expenditure and GNPAn increase in the Public expenditure raises

the level GNP .Public expenditure in the form of purchase of

goods and services increases income and business profit, which in turn increases government’s tax revenue.

Taxation and GNP

Direct taxes without an equivalent public expenditure have adverse effect on GNP.

Increase in taxation either due to increase in the rates of existing taxes, or due to imposition of new taxes, reduces GNP.

The size of decrease in GNP as a result of increase in taxation depends on the tax multiplier.

Counter cycle business policy : automatic and discretionary changes

It require increase in public expenditure and reduction in taxes to fight depression ,and reduction in public expenditure and increase in taxation to control inflation.

Fighting depression would require a deficit budgeting and controlling inflation requires surplus budgeting.

Monetary policies

A central bank creates monetary policy by controlling the money supply and the interest rate . These policies aim to stabilize an economy by encouraging borrowing and investment, and controlling unemployment and inflation.

It is to regulate demand and supply of money with public.

Traditional monetary instruments1. Open market operation2. Changes in bank rate3. Changes in the statutory reserve ratios

Open market operation

It is an activity by a central bank to buy or sell government bonds on the open market.

A central bank uses them as the primary means of implementing monetary policy.

During the period of expansion, the central bank sells the government bonds and securities to the public.

During the period of depression, the central bank buys the government securities.

The bank rate or rediscount rate

It is the rate at which the central bank rediscounts the bills of exchange presented by the commercial bank.

For controlling inflation the central bank will raises the bank rate, which will discourages public borrowing from commercial banks.

The bank rate will be lowered, which will leads to monitory expansion and works against the forces of depression.

Cash reserve ratio

It is the percentage of total deposits which the commercial banks are required to maintain in the form of cash reserve with the central bank.

When the central bank wants to reduce the credit creation capacity of the commercial banks, it increases the ratio of there demand and time deposits to be held as reserve with the central bank.

Conclusion

The fiscal and monetary policies may be alternatively or simultaneously used to control business cycles in the economy.

Monetary policy is considered to be more effective to control inflation than to control depression .

An appropriate mix of fiscal and monetary policies would always prove more effective than a single policy.