The Limits to Stabilization Policy

THE LIMITS TO STABILIZATION POLICY

A stabilization policy is an action taken to move the economy closer to full employment or potential output. Both expansionary and contractionary policies are examples of stabilization policies, actions to move the economy closer to full employment or potential output. It is very difficult to implement stabilization policies for two big reasons. First, there are lags, or delays, in stabilization policy. Lags arise because decision makers are often slow to recognize and respond to changes in the economy, and fiscal policies and other stabilization policies take time to operate. Second, economists simply do not know enough about all aspects of the economy to be completely accurate in all their forecasts. Although economists have made great progress in understanding the economy, the difficulties of forecasting the precise behavior of human beings, who can change their minds or sometimes act irrationally, place limits on our forecasting ability. Successful stabilization policies can dampen, that is, reduce in magnitude, economic fluctuations, lowering output when it exceeds full employment and raising output when it falls below full employment. This would be easy to accomplish if there were no lags in policy. The dashed curve shows how successful policies can reduce economic fluctuations.

Economists recognize two broad classes of lags: inside lags and outside lags. Inside lags refer to the time it takes to formulate a policy. Outside lags refer to the time it takes for the policy to actually work. To help you understand inside and outside lags, imagine that you are steering a large ocean liner and you are looking out for possible collisions with hidden icebergs. The time it takes you to spot an iceberg, communicate this information to the crew, and initiate the process of changing course is the inside lag. Because ocean liners are large and have lots of momentum, it will take a long time before your ocean liner begins to turn; this time is the outside lag. Inside lags occur for two basic reasons. One is that it takes time to identify and recognize a problem. For example, the data available to policymakers may be poor and conflicting. Some economic indicators may look fine, but others may cause concern. It often takes several months to a year before it is clear that there is a serious problem with the economy. A good example of an inside lag occurred at the beginning of the Great Depression. Although the stock market crashed in October 1929, we know from newspaper and magazine accounts that business leaders were not particularly worried about the economy for some time. Not until late in 1930 did the public begin to recognize the severity of the depression. The other reason for inside lags is that once a problem has been diagnosed, it still takes time before the government can take action. In recent years, political opponents have been preoccupied with disagreements about the size of the government and the role it should play in the economy, making it difficult to reach a consensus on action in a timely manner.

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