Macroeconomics

9-5

Stabilization Policy

Fluctuations in the economy as a whole come from changes in aggregate supply

or aggregate demand. Economists call exogenous events that shift these curves

shocks

to the economy. A shock that shifts the aggregate demand curve is called

a demand shock, and a shock that shifts the aggregate supply curve is called a

supply shock.

These shocks disrupt the economy by pushing output and

employment away from their natural levels. One goal of the model of aggregate

supply and aggregate demand is to show how shocks cause economic fluctuations.

Another goal of the model is to evaluate how macroeconomic policy can

respond to these shocks. Economists use the term stabilization policy to refer

to policy actions aimed at reducing the severity of short-run economic fluctua-

tions. Because output and employment fluctuate around their long-run natural

levels, stabilization policy dampens the business cycle by keeping output and

employment as close to their natural levels as possible.

In the coming chapters, we examine in detail how stabilization policy works

and what practical problems arise in its use. Here we begin our analysis of 

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P A R T   I V

Business Cycle Theory: The Economy in the Short Run

FYI

As Chapter 4 noted, many of the central ideas of

monetary theory have a long history. The classi-

cal theory of money we discussed in that chapter

dates back as far as the eighteenth-century

philosopher and economist David Hume. While

Hume understood that changes in the money

supply ultimately led to inflation, he also knew

that money had real effects in the short run. Here

is how Hume described a monetary injection in

his 1752 essay Of Money:

To account, then, for this phenomenon, we must

consider, that though the high price of commodities

be a necessary consequence of the increase of gold

and silver, yet it follows not immediately upon that

increase; but some time is required before the money

circulates through the whole state, and makes its

effect be felt on all ranks of people. At first, no alter-

ation is perceived; by degrees the price rises, first of

one commodity, then of another; till the whole at

last reaches a just proportion with the new quantity

of specie which is in the kingdom. In my opinion, it

is only in this interval or intermediate situation,

between the acquisition of money and rise of prices,

that the increasing quantity of gold and silver is

favorable to industry. When any quantity of money

is imported into a nation, it is not at first dispersed

into many hands; but is confined to the coffers of a