Chapter 17, Problem 1AA

To determine

To evaluate how the government tries to ensure economic stability by using stabilization policy, the unemployment rate, demand pull inflation, cost pull inflation, fiscal policy, circular flow of income, monetarism, monetary rule, inflation targeting and time lags.

Explanation of Solution

An approach adopted by a government or its central bank to sustain a stable level of economic growth and gradual changes in prices is called a stabilization policy. Sustaining a policy of stabilization involves tracking the market cycle and modifying benchmark interest rates as required to manage sudden increases in demand. Often the term stabilization policy is used to define intervention of the government responding to a crisis of economy or shock, such as a debt of sovereign or a crash of stock market. The responses can include emergency measures and changes to legislation.

The unemployment rate reflects the proportion of the jobless population. It is a lagging measure, which means it normally rises or falls in the wake of shifting economic conditions instead of predicting them. The unemployment rate can be expected to increase when the economy is in bad shape and jobs are scarce. If the economy rises at a steady rate, and jobs are relatively abundant, it can be expected to decline.

Typically, the term inflation with demand-pull defines a common phenomenon. That is, as market demand outstrips the existing supply of several forms of consumer goods, demand-pull inflation sets in, causing an overall cost of living rise. A rise in jobs in Keynesian economic theory contributes to an increase in overall demand for consumer goods. Companies recruit more workers in response to the demand, so they can increase their production. The more workers businesses recruit, the higher the jobs. The demand for consumer products inevitably outstrips manufacturers' capacity to produce them.

Cost-push inflation happens when the average costs (inflation) rise due to labor and cost of raw material rises. Higher production costs in the economy will lower the aggregate supply (the sum of total output). Because demand for goods has not changed, the price rises resulting from output are transferred on to customers causing the cost-push inflation.

Fiscal policy refers to the utilization of spending of the government and policies of tax to control economic circumstances like aggregate demand for goods and services, inflation, wages, and development of the economy. Fiscal policy is primarily concentrated on the Philosophies of the economist JMK, who concluded that economic recessions are due to a deficit in consumer consumption and the factors of aggregate demand for business investment

Theconcept of circular flow illustrates how the money flows through society. Money flows as salaries from producers to workers, and as payment for goods flows back to producers. In short, an economy is an interminable revolving money flow. Money is removed or leaked by different means just as money is pumped into the economy. Government-imposed taxes (T) limit the flow of revenue. Often a leakage is money paid to foreign firms for imports (M).

Monetarism is an economic line of thought which asserts that the driving force of growth of the economy is the money supply in an economy. As capital becomes more available in the economy, aggregate demand for goods and services rises. A rise in aggregate demand fosters job formation, which decreases the unemployment rate and increases economic development.

Monetary rule comprises of the system of drawing up, issuing and enforcing the action plan of a country's central bank, currency board or other competent monetary authority which controls the amount of money in an economy and the channels through which new money is provided. Monetary policy includes managing money supply and rates of interest to achieve macroeconomic goals such as controlling inflation, demand, productivity, and liquidity.

Time lags play an important part in economic policy performance. Interest-rate cuts are expected to take up to 18 months to have their full effect. This suggests that the past few months' rate cuts will not have full effect until mid-2010. The economy may have stabilized from the recession by that point. It's the same for monetary policy, if the government plans to boost spending, e.g. advance budget plans, the fiscal stimulus will also take several months to kick in.

Economics Concept Introduction

Introduction: An economy is the broad set of interconnected production and consumption activities which help to decide how limited resources are distributed. The distribution and production of goods and services are used to meet the needs of those who live and work within the economy, often referred to as an economic system.