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The Roots of Stabilization Policy

• Pioneering economist John Maynard Keynes argued that an economy can experience a sharp and sustained period of stagnation without a any kind of natural or automatic rebound or correction. Previous economists had observed that economies grow and contract in a cyclical pattern, with occasional downturns followed by a recovery and return to growth. Keynes disputed their theories that a process of economy recovery should normally be expected after a recession. He argued that the fear and uncertainty that consumers, investors, and businesses face could induce a prolonged period of reduced consumer spending, sluggish business investment, and elevated unemployment which would all reinforce one another in a vicious circle.

• To stop the cycle, Keynes argued, requires changes in policy in order to manipulate aggregate demand. He, and the Keynesian economists who followed him, also argued the reverse policy could be used to fight off excessive inflation during periods of optimism and economic growth. In Keynesian stabilization policy, demand is stimulated to counter high levels of unemployment and it is suppressed to counter rising inflation. The two main tools in use today to increase or decrease demand are to lower or raise interest rates for borrowing or to increase of decrease government spending. These are known as monetary policy and fiscal policy, respectively.