Quiz 15: Stabilization Policy, Output, and Employment


Economic instability has been much less severe during the past sixty years compared with instability prior to World War II. Prior to World War II, 5 to 10 percent change in real GDP in year on year basis has been observed on several occasions whereas in past sixty years such large fluctuations in real GDP has not been witnessed even once. Fluctuations in real GDP have occurred but those fluctuations have been much more moderate. In fact, in 25 year period from 1983-2007, U.S. economy was in recession for only 6 percent of time. Apart from this, most of the severe recession in U.S. economic history has been observed prior to the World War II. As we know that monetary policy that maintains a low rate of inflation or maintains price stability is key ingredient of any stabilization policy that can be termed as effective. In past sixty years, Fed has administered a monetary policy that has kept the inflation rate lower or has maintained the price stability which has created greater stability in recent years. Secondly, if we analyze the severity of downturn in U.S. economy in recent decades then barring recession of 2008, U.S. economy has been in recession for only eighteen months out of the twenty five year period from 1983-2007. Thus, above pieces of evidences clearly prove that stabilization policy has increased the economic stability during recent decades.

Adaptive-Expectations Hypothesis According to this hypothesis, a person while making a decision with regards to the future time period generally rely on information from the past time period. In other words, happenings of recent past are considered as best indicators to base the future expectations. Difference between the theory of rational expectations and adaptive expectations are as follows - 1. According to theory of adaptive expectations, people adjust to economic changes in much slower manner on the other hand according to theory of rational expectations; people adjust to economic changes in faster manner. In fact, as per this theory, sometimes people adjust their behavior mush before actual changes in economic scenario has taken place. 2. Theory of adaptive expectations is more prone to systematic errors than theory of rational expectations. In fact, errors are random under the theory of rational expectations rather than be systematic.

Index of Leading Indicators This is an index or collection of several economic variables that has historic tendency to show downward movement before the start of a recession and to show upward movement before the start of expansion. Index of leading indicators is considered one of the most valuable forecasting tools to forecast the future direction of the economy. It is useful to the macro policy makers because this index provides a glimpse of future direction of economy and thus provides a window to the macro policy makers to formulate appropriate policy response. For example, if index of leading indicators is predicting recessionary conditions in the economy then monetary authorities can utilize these signals and respond with expansionary monetary policy to negate the recession and save the economy from future instability.

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