STABILIZATION FUNCTION
The theoretical rationale for the stabilization function of the government is derived from the Keynesian proposition that a market economy does not automatically generate full employment and price stability and therefore the governments should pursue deliberate stabilization policies. Business cycles are natural phenomena in any economy and they tend to occur periodically. The market system has inherent tendencies to create business cycles. The market mechanism is limited in its capacity to prevent or to resolve the disruptions caused by the fluctuations in economic activity. In the absence of appropriate corrective intervention by the government, the instabilities that occur in the economy in the form of recessions, inflation etc. may be prolonged for longer periods causing enormous hardships to people especially the poorer sections of society. It is also possible that a situation of stagflation (a state of affairs in which inflation and unemployment exist side by side) may set in and make the problem more intricate.
The stabilization issue also becomes more complex as the increased international interdependence causes forces of instability to get easily transmitted from one country to other countries This is also known as contagion effect”.
The stabilization function is one of the key functions of fiscal policy and aims at eliminating macroeconomic fluctuations arising from suboptimal allocation. As you might recall, the economic crisis that engulfed the world in 2008 and the more recent euro area crisis have highlighted the importance of macroeconomic stability and has, therefore, revived interest in countercyclical fiscal policy.
The stabilization function is concerned with the performance of the aggregate economy in terms of:
- labour employment and capital utilization,
- overall output and income,
- general price levels,
- balance of international payments, and
- the rate of economic growth.
1. an overall effect generated by the balance between the resources the government puts into the economy through expenditures and the resources it takes out through taxation, charges, borrowing etc.
2. a microeconomic effect generated by the specific policies it adopts.
Government’s stabilization intervention may be through monetary policy as well as fiscal policy. Monetary policy has a singular objective of controlling the size of money supply and interest rate in the economy which in turn would affect consumption, investment and prices. Fiscal policy for stabilization purposes attempts to direct the actions of individuals and organizations by means of its expenditure and taxation decisions. On the expenditure side, Government can choose to spend in such a way that it stimulates other economic activities. For example, government expenditure on building infrastructure may initiate a series of productive activities. Production decisions, investments, savings etc can be influenced by its tax policies.
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