STABILIZATION POLICY

What is Stabilization Policy?

A stabilization policy is a macroeconomic strategy enacted by governments and central banks to keep economic growth stable, along with price levels and unemployment. Ongoing stabilization policy includes monitoring the business cycle and adjusting benchmark interest rates to control aggregate demand in the economy. The goal is to avoid erratic changes in total output as measured by gross domestic product (GDP), and large changes in inflation. Stabilization of these factors generally leads to moderate changes in the employment rate as well.

In modem times, a programme of economic stabilization is usually directed towards the attainment of three objectives: (i) controlling or moderating cyclical fluctuations; (ii) encouraging and sustaining economic growth at full employment level; and (iii) maintaining the value of money through price stabilization. Thus, the goal of economic stability can be easily resolved into the twin objectives of sustained full employment and the achievement of a degree of price stability.

Types of Stabilization Policies Includes:

·         Monetary Policy

·         Fiscal Policy

·         Exchange rate Policy

·         Supply side Policy.

Monetary Policy

Monetary policy can be defined as a policy in which the monetary authority of a country, generally the central bank, controls the demand and supply of money.

It can also be defined as the use of money supply by the appropriate authority (i.e. central bank) to achieve certain economic goals. Whenever there is a change in money supply there occurs a change in the rate of interest. Thus, monetary policy influences interest rate or cost and availability of credit.

When the central bank attempts to contract money supply through various credit control instruments so as to restrain the economy, the situation is then called tight/contractionary monetary policy. Oppositely, an easy/expansionary monetary policy is employed to boost the economy by increasing money supply through its credit control instruments.

Monetary authority employs monetary policy to influence aggregate demand in order to achieve higher levels of income and employment. The mechanism—called money transmission mechanism—that influences aggregate demand follows the following course.

An increase in money supply by the central bank will mean more money in the pockets of firms and households. Faced with more money, people will buy more financial assets, such as bonds. Consequently, bond prices will go up and interest rates will decline. This will stimulate consumption and investment spending, thereby raising aggregate demand and, hence, level of income and employment.

Objectives of Monetary policy

(i) Maintaining internal and external stability;

(ii) High employment;

(iii) Economic growth;

(iv) Fiscal objectives; and

(v) Social objectives.

(i) Maintaining Price Stability:

By price stability, we mean both internal and external stability in the price level. Price fluctuations of a larger degree are always unwelcome.

Sustained increase in price level has a destabilizing effect on the economy. A falling price level has more destabilizing influence on the economy. In other words, both inflation and depression must be controlled so that benefits of economic development are reaped. Price stability prevents not only economic fluctuations but also helps in the attainment of a steady growth of an economy.

(ii) High Employment:

Though it is difficult to give a precise definition of full employment, monetary policy during the 1930s aimed at achieving and maintaining full employment. Further, full employment, though theoretically conceivable, is difficult to attain in market-driven economies.

A country must aim at attaining at least near full employment situation. By pushing up aggregate demand (C + I + G), a country can prevent wastes of labour. And, aggregate demand gets to be stimulated by applying appropriate monetary policy instruments

(iii) Economic Growth

By economic growth we mean an increase in per capita output. In a market economy, economic growth is conditioned by the productive capacity or capital stock of the economy. Economic growth requires an increase in saving and investment. Monetary policy can contribute towards economic growth by raising saving-income ratio.

(iv) Fiscal Objectives:

The most important fiscal objective which monetary policy has to pursue is that of facilitating government borrowing and the management of public debt. In the interest of a sound debt management policy, monetary policy is employed so that an orderly condition in the security market is established.

It is to be remembered here that, in practice, both the fiscal and monetary policy objectives are likely to be mixed up. In reality, it becomes difficult to draw a line of demarcation of one objective from that of another.

(v) Social Objectives:

Monetary policy is often used to attain some social ends or social welfare. By raising or lowering price level, monetary policy can produce far-reaching social effects of redistribution of wealth. One of the most important objectives of the pursuit of monetary stability is to maintain the social status quo.

Tools of Monetary Policy:

Quantitative Measures

Open Market Operations:

Open Market Operations (OMO) of a government involve the sales and purchase of government securities and treasury bills by the central bank. If the central bank wants to increase the supply of money with the public, it purchases government securities and treasury bills. On the other hand, if the central bank wants to decrease the supply of money, it sells the government securities and treasury bills. OMO is the most important and frequently adopted measure of the monetary policy.

Bank Rate Policy:

Bank rate refers to the rate at which the central bank further discounts the bills of exchange presented by commercial bank. The central bank can rediscount the approved bills and bills of exchange only. If commercial banks are not left with adequate cash reserves, they are required to consult the central bank for rediscounting their bills of exchange. In this way, commercial banks borrow from the central bank. The central bank rediscounts the bills of exchange of commercial banks as it is one of the functions of the central bank. Increase in bank rate reduce money supply, while a reduction in bank rate, reduces money supply.

Cash Reserve Ratio:

CRR refers to the percentage of credit that needs to be maintained by commercial banks in the form of cash reserve with the central bank. An increase in reserve rate will reduce the money supply while a decrease in reserve rate will increase money supply.

Selective Credit Controls / Qualitative measures.:

The quantitative measures of monetary control have uniform effect on the whole credit market. In simple terms, these measures have an even effect on all the sectors of an economy. However, this situation may not always wanted by policymakers for the formulation of policies.

This is because of the reason that policymakers need to allocate the money in different sectors of the society and move the flow of money from most important sectors to least important sectors of the economy. In addition, the policymaker’s nave to reduce the risk factors associated with the availability of bank credit.

All these objectives of monetary control can be achieved by implementing quantitative measures. Therefore, several selective credit controls are introduced by monetary authorities.

Some of the measures under selective credit controls are as follows:

(a) Credit Rationing:

Refers to one of the important measures to control money supply. The allocation of money is different in different sectors of an economy. In case there is reduction in money supply in an economy, then large industries are generally inclined to hold the largest share of the total money supply in the market. In such a case, those industries that are important for economic growth, but are not very strong suffer from the problem of lack of money.

(b) Moral Suasions:

Refers to a measure of assuring and influencing commercial banks to raise credit in alignment with the directives set by the central bank. The moral suasion method is used when other quantitative measures of monetary policy are not effective for monetary control.

In this method, the central bank conducts meetings with commercial banks and writes letters to them. The main purpose of holding meetings is to persuade commercial banks to work as per the rules of the central bank and for the welfare of the economy.

(c) Direct Controls:

Refer to measures when other monetary control measures of the central bank fail to control the situation. In such a condition, commercial banks need to perform their lending activities according to the instructions of the central bank.

Fiscal Policy

Fiscal policy generally refers to the use of taxation and government expenditure to regulate the aggregate level of economic activity. Thus, if unemployment is regarded as too high, income and expenditure taxes may be varied to stimulate the level of aggregate expenditure (demand).

Fiscal policy must be designed to be performed in two ways-by expanding investment in public and private enterprises and by diverting resources from socially less desirable to more desirable investment channels.

The objective of fiscal policy is to maintain the condition of full employment, economic stability and to stabilize the rate of growth.

For an under-developed economy, the main purpose of fiscal policy is to accelerate the rate of capital formation and investment.

Generally following are the objectives of a fiscal policy in a developing economy:

1. Full employment

2. Price stability

3. Accelerating the rate of economic development

4. Optimum allocation of resources

5. Equitable distribution of income and wealth

6. Economic stability

7. Capital formation and growth

8. Encouraging investment

Exchange Rate Policy

The exchange rate policy refers to the manner in which a country manages its currency in respect to foreign currencies and the foreign exchange market. The exchange rate is the rate at which the domestic currency can be converted into a foreign currency.

The main objectives of exchange rate policy in Nigeria are to preserve the value of the domestic currency, maintain a favourable external reserves position and ensure external balance without compromising the need for internal balance and the overall goal of macroeconomic stability.

Supply-Side Policy

Supply Side Policies are policies aimed at increasing Aggregate Supply (AS), a shift from left to right. They enhance the productive capacities of an economy while improving the quality and quantity of the four factors of production. However, supply side policies are difficult to implement and take time to take effect.

Policies designed to correct Balance of Payment equilibrium.

(i) Trade Policy Measures: Expanding Exports and Restraining Imports:

Trade policy measures to improve the balance of payments refer to the measures adopted to promote exports and reduce imports.

Exports may be encouraged by reducing or abolishing export duties and lowering the interest rate on credit used for financing exports. Exports are also encour­aged by granting subsidies to manufacturers and exporters.

(ii) Expenditure-Reducing Policies:

The important way to reduce imports and thereby reduce deficit in balance of payments is to adopt monetary and fiscal policies that aim at reducing aggregate expenditure in the economy. The fall in aggregate expenditure or aggregate demand in the economy works to reduce imports and help in solving the balance of payments problem.

The two important tools of reducing aggregate expen­diture are the use of:

(1) Tight monetary policy and

(2) Concretionary fiscal policy.

Tight Monetary Policy:

Tight monetary is often used to check aggregate expenditure or demand by raising the cost of bank credit and restricting the availability of credit. For this bank rate is raised by the Central Bank of the country which leads to higher lending rates charged by the commercial banks. This discourages businessmen to borrow for investment and consumers to borrow for buying durable consumers goods.

This therefore leads to the reduction in investment and consumption expenditure. Besides, availability of credit to lend for investment and consumption purposes is reduced by raising the cash reserve ratio (CRR) of the banks and also undertaking of open market operations (selling Government securities in the open market) by the Central Bank of the country.

Contractionary Fiscal Policy:

Appropriate fiscal policy is also an important means of reduc­ing aggregate expenditure. An increase in direct taxes such as income tax will reduce aggregate expenditure. A part of reduction in expenditure may lead to decrease in imports. Increase in indirect taxes such as excise duties and sales tax will also cause reduction in expenditure.

The other fiscal policy measure is to reduce Government expenditure, especially unproductive or non-developmen­tal expenditure. The cut in Government expenditure will not only reduce expenditure directly but also indirectly through the operation of multiplier.

(iii) Expenditure – Switching Policies: Devaluation:

A significant method which is quite often used to correct fundamental disequilibrium in balance of payments is the use of expenditure-switching policies. Expenditure switching policies work through changes in relative prices. Prices of imports are increased by making domestically produced goods relatively cheaper. Expenditure switching policies may lower the prices of exports which will encourage exports of a country. In this way by changing relative prices, expenditure-switching poli­cies help in correcting disequilibrium in balance of payments.

The important form of expenditure switching policy is the reduction in foreign exchange rate of the national currency, namely, devaluation. By devaluation we mean reducing the value or exchange rate of a national currency with respect to other foreign currencies.

ARTICLE BY MONDAY DESMOND