3. Types of Stabilization policy

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ECONOMICS PAPER 7 : Theory of Public Finance

MODULE 22 : Role of Uncertainty and Expectations in formulating Stabilization policy

Subject Economics

Paper No and Title 7: Theory of Public Finance

Module No and Title 22: Role of Uncertainty and Expectations in formulating Stabilization policy

Module Tag ECO_P7_M22

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1. Learning Outcomes 2. Introduction

3. Types of Stabilization policy

4. Role of expectation in stabilization policy

5. Role of uncertainty in stabilization policy

6. Summary

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1. Learning Outcomes

After studying this module, you shall be able to

 Know about the stabilization policy

 Learn about the types of stabilization policy

 Identify the role of uncertainty

 Evaluate the role of expectations

 Analyze the formulation of stabilization policy

2. Introduction

Economic fluctuations are present in all walks of life. Each and every country face economic fluctuations. These economic fluctuations affect the growth, stability and distribution pattern in the economy. These three areas have always been the major source of attention for government officials. Growth can be defined as increase in real national income in the country and stability can be defined as absence of fluctuations in the income, price and unemployment level in the economy and distribution comprises of distribution of income among various households present in the economy. No country can be saved from the shocks of economic fluctuations. The major cause of economic fluctuation is risk and uncertainty prevailing in the economic system, so government tries to reduce the risk and uncertainty by making various stabilization policies. Tough these policies cannot fully save the economy from the jerks of economic fluctuations but still these policies try to reduce their after effects up to a certain extent.

3. Types of Stabilization policy

Stabilization policy is a set of measures undertaken by the government to stabilize the financial system in the economy. It also refers to correcting the normal behavior of the business cycle in the economy. Stabilization policies are also termed as economic policies which are undertaken by the government to control fluctuations in business cycle and

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prevent from high rate of inflation and unemployment that can prevail in the economy.

These policies are also known as counter cyclical policies because they counter the ups and downs of business cycle. Thus these policies are various actions undertaken by the government especially monetary and fiscal policy designed to control the unemployment and inflation problem created in the economy by various economic fluctuations in the business cycle.

There are mainly three types of policies which are use to control economic fluctuations and tries to maintain price stability and helps in attaining a level of economic growth in the economy. The three types of policies are

(a). Monetary Policy.

(b). Fiscal Policy.

(c). Direct Controls.

(a). Monetary Policy:

The most common policy framed by the government for solving the problems of economic fluctuations is monetary policy. Monetary policy is related with banking system like credit given by banks and availability of loans to individuals and households. It also covers management of interest rates, public debt and monetary management in the economy. The biggest problem with monetary policy is to control and regulate the volume of credit in the economy as to maintain a proper level of growth and stability in the economy. During the phase of depression credit must be expanded and during time of boom credit flow should be restricted. Monetary management affects the cash reserves of the banks because it helps in regulating the supply of money and credit in the economy by influencing the interest rates and availability of credit in the economy. When bank credit is expanded then flow of expenditure increases and when bank credit is contracted then flow of expenditure reduces from the economic system. There are two types of monetary policy, expansionary and contractionary. Expansionary monetary policy increases the money supply in order to lower unemployment, boost private sector and stimulate economic growth. This policy is also refereed as easy monetary policy. Contractionary monetary policy slows the rate of growth in money supply in order to control inflation, while sometimes this policy can slow

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economic growth, increase unemployment and depress borrowing and spending by consumers and businesses.

There are various quantitative and qualitative measures undertaken to control the credit creating activity of the banking system:

(i). Bank rate policy:

Bank rate is also known as discount rate. It is the rate of interest which central bank charges on the loans and advances given to a commercial bank. When commercial bank has shortage of funds they can borrow money from the central bank. Borrowing of money by commercial banks is being done through repo rate. If repo rate is reduced then the banks will get credit at a cheaper rate and if repo rate is increased then the commercial bank have to borrow loans at an expensive rate. Fixation of bank rate is being done to control inflation and to maintain stability in the economy.

(ii). Open market operations:

Open market operations refer to buying and selling of government securities in the open market in order to expand or restrict the amount of money in the banking system. If RBI wants to increase the flow of funds in the economy then they will buy the government securities and invest in various funds, but when they want to reduce the flow of money from the economy then they will sell the securities to the commercial banks. Thus open market operations are being done to make the bank rate policy effective.

(iii). Reserve ratios:

Reserve ratio is also known as cash reserve ratio. This ratio is the percentage of deposits which the commercial banks have to keep in cash according to the instructions of the central bank. When central bank wants to increase the money supply in the economy then they will lower the reserve ratio and when the bank wants to decrease the money supply then they will decrease the reserve ratio. Thus it serves a very important tool for controlling inflation and also a very important tool of monetary policy.

(iv). Selective Controls:

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Selective control means to regulate the flow of credit for particular purpose. The concept of selective control was opted from the USA to regulate the flow of credit to the stock market. But in India this method is being used to prevent speculative hoarding of commodities and keep a check in the prices of the commodities. The selective control method in India is being used in case of mainly agricultural products like food grains, oils, sugar cotton etc. This concept came into operation in India in 1956 to keep a check in the rise in prices of agricultural commodities and which are sensitive in nature. This scheme will be successful only when there will be a variation in bank rate policy and reserve ratio.

(b). Fiscal Policy:

Fiscal policy is also one of the tools for economic stability, but this policy received importance in 1930 at the time of Keynes when situation of depression was prevailing in the economy. Fiscal policy is related with the tax and expenditure policy of the government. A Smithies defined fiscal policy as,” a policy under which the government uses its expenditure and revenue programmes to produce desirable effects and avoid undesirable effects on the national income, production and employment. Fiscal policy is being operated through the control of government expenditures and tax receipts. This policy relates to keep a check and strict control on private spending. It also deals with various channels by which government spending on new goods and services entering in the economy can directly add in aggregate demand and indirectly a addition in the income of the government through the concept of multiplier effect. For effective working of the fiscal policy it should be planned carefully keeping in view the short and long range of plans. Thus it should be planned on both long and short term basis. Fiscal policy operates through two mechanism automatic stabilizers and discretionary action. Automatic stabilizers are the government programmes which tend to reduce fluctuation in GDP automatically. These stabilizers automatically save the economy from the various shocks that have arisen due to changes in the tax and expenditure policy of the government. When fiscal policy works under the framework of various rules and regulations then it is known as discretionary policy.

(c). Direct Control:

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Direct control is being imposed by the government which restricts certain kinds of investment in the economy. Sometimes control over wages and prices during inflation is also a measure by the government which is being implemented in the economy. This kind of measure is being used only in times of emergency.

4. Role of expectations in stabilization policy

The formation of expectations has an important role to play in economics and stands in the mainstream while framing stabilization policy. Research by various economists shows that each and every person form expectations about their future, whether consumers, they form expectations about their future income and to smoothen their future consumption, firms use to form expectations to increase their profitability by increasing their production, investors use to form expectations to increase their profitability and for how long they should invest in company’s stocks, factory employees usually make expectations about the future level in prices which will help in negotiating their wage contracts. Thus we can say that expectations are present in every walks of life and every person use to form expectations. Thus expectations can be defined as set of assumptions people make about what will happen in future. These assumptions serve as a guiding factor to individuals, businessman and government in their day to day decision making process. People use to guess about what will occur in the future and these future assumptions affect almost the entire economy. For example if a businessman dealing in air conditioners expects that in the near future the demand for AC will increase then he can think of appointing the additional staff for production purpose otherwise he will reduce the fresh production. There are two types of expectations which help in the formulation of stabilization policy:

(a). Adaptive expectations: These expectations are those expectations in which people use past information as a predictor for their future events. Individuals use to form their expectations about the future on the basis of the data gathered from the recent past.

Adaptive expectations is more frequently used in economics. Adaptive expectations are effective when the variable being forecast is reasonably stable but adaptive expectations are of little use in forecasting trends. For example if inflation was higher than normal in the past people will expect it to be higher than anticipated in the near future.

(b). Rational expectations: John Muth is called the father of rational expectations. In this type of expectation people use all available past and current information for predicting

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future events. For example the value of a share of stock is always dependent on the expected future income from that stock.

According to the various type of expectations prevailing in the economy policy makers use to frame a suitable stabilization policy. The role of adaptive expectations is less while framing stabilization policy because only past information is being taken into consideration which can misled the various economic agents who are relying on such policy, but the role of rational expectations is of great value while framing a stabilization policy because both past and present information is being taken into consideration in case of rational expectations. The government use to consider both past and present information while framing monetary or fiscal policy. If government anticipates that inflation will occur in the near future, then government will prepare an expansionary monetary policy for the country.

Thus expectations play a very important role in the formulation of stabilization policy. For example the price of an agricultural commodity is always dependent on how much acre of land is being used by the farmer in plantation of the agricultural commodity. If more land is being used by the farmer it means more plants are being harvest so the prices will also be according the plant harvested.

5. Role of Uncertainty in stabilization policy

Uncertainty is one of the most important elements of Keynes theory of General employment. HM Minsky said that Keynes without uncertainty is like Hamlet without prince (Minsky 1975 pg 57). GLS shackle offered the same opinion when he declared that uncertainty is the very bedrock of Keynes theory of employment (Shackle 1967 pg 112).

The concept of uncertainty was given by Keynes but this concept later on being used by James Tobin in 1970.

According to Keynes (Treatise on probability 1921 pg 21) “Uncertainty refers to a situation in which knowledge concerning the future effects of our current actions does not and cannot exist”. Thus uncertainty reflects lack of knowledge where probabilities for future outlook are unknown. Uncertainty in simple words in economics means the future outlook for the economy which is unpredictable. People are not in a position to predict what will happen in the future because of uncertainty prevailing in the economic environment. In economics uncertainty means that the future outlook for the economy is unpredictable. Due to uncertain environment policy makers also faces a lot of difficulty in making the policy

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because policy makers do not know the precise value of multipliers. Each and every person is being affected due to uncertainty, whether individuals, investors, government, businessman, and policy makers. Individual expect a higher income in the future but it is not necessary that their income level would increase because of uncertainty, investors expect a high dividend but it depends on the profitability condition of the company in near future. So we can say that expectations give rise to uncertainty, thus expectations and uncertainty go side by side or in other words they are the two sides of the same coin.

Uncertainty also plays a prominent role while framing stabilization policy. The government and policy makers face a lot of difficulty while framing stabilization policy because of uncertain economic environment. The government is always uncertain about how the economy will react to policy changes. Government and policy makers are not aware about the true structure of the economy, so they find a lot of difficulty while formulating a stabilization policy. For example if government expects that inflation will increase in the near future, so the government will prepare a tight monetary policy and make credit costly to control inflation, but it’s not necessary that the expectations of the government proves to be true because of high level of uncertainty present in the economic environment. Thus a tight monetary policy by the government can lead to deflation in the economy. Thus government always works in a situation of fear and confusion, that if any changes in the policy or any policy framed by the government will affect the economy. Government though uses various econometric models to study the effects of policy changes but still after effects will be seen in the economy because of uncertain economic environment and the government is not fully aware about the true model of the economy. If consumer expectations changes then it will also affect the stabilization policy, and changes in expectations will lead to a disturbance in the monetary and financial policy of the government. Policy makers can be wrong in framing a stabilization policy if expectations of the consumers and individual changes in the near future. For example it is very difficult to fix the price of the oil, because prices of oil changes now and then due to the changes in the policy of the countries having oil reserves. Thus it can be said that uncertainty disturbs the policy makers while framing the stabilization policy and the economy has to face ups and downs due to high level of uncertainty present in the economic system.

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6. Summary

 The major cause of economic fluctuation is risk and uncertainty prevailing in the economic system, so government tries to reduce the risk and uncertainty by making various stabilization policies.

 Stabilization policy is a set of measures undertaken by the government to stabilize the financial system in the economy. It also refers to correcting the normal behavior of the business cycle in the economy.

 There are mainly three types of policies which are used to control economic fluctuations and tries to maintain price stability and helps in attaining a level of economic growth in the economy. The three types of policies are monetary policy, fiscal policy and direct control.

 The formation of expectations has a important role to play in economics and stands in the mainstream while framing stabilization policy.

 According to Keynes (Treatise on probability 1921 pg 21) “Uncertainty refers to a situation in which knowledge concerning the future effects of our current actions does not and cannot exist”. Thus uncertainty reflects lack of knowledge where a probability for future outlook is unknown. Uncertainty in simple words means the ability to forecast future event.

3. Types of Stabilization policy

TABLE OF CONTENTS

1. Learning Outcomes 2. Introduction

3. Types of Stabilization policy

4. Role of expectation in stabilization policy

5. Role of uncertainty in stabilization policy

6. Summary

1. Learning Outcomes

2. Introduction

3. Types of Stabilization policy

4. Role of expectations in stabilization policy

5. Role of Uncertainty in stabilization policy

6. Summary