Role of Expectations and Uncertainty in Formulating Economic Stabilization Policy

7 months ago

Atiqur Rahman

16 minutes

Introduction

Economic fluctuations are present in all walks of life. Each and every country faces economic fluctuations. These economic fluctuations affect the growth, stability and distribution pattern of the economy. These three areas have always been the major source of attention for government officials.

Growth can be defined as the increase in real national income in the country, and stability can be defined as the absence of fluctuations in the income, price and unemployment level in the economy and distribution comprises the 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 the government tries to reduce the risk and uncertainty by making various stabilization policies. Though these policies cannot fully save the economy from the jerks of economic fluctuations but these policies still try to reduce their after-effects up to a certain extent.

Types of Economic Stabilization Policy

A 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 behaviour 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 the business cycle and prevent from a 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 the 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 three types of policies which are used to control economic fluctuations and try to maintain price stability and help 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

Monetary Policy:

The most common policy framed by the government for solving the problems of economic fluctuations is monetary policy. Monetary policy is related to the banking system, like credit given by banks and the 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 so as to maintain a proper level of growth and stability in the economy. During the phase of depression, credit must be expanded, and during times of boom, credit flow should be restricted.

Monetary management affects the cash reserves of the banks because it helps to regulate 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 the flow of expenditure increases and when bank credit is contracted, the 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 the private sector and stimulate economic growth. This policy is also referred to as easy monetary policy. Contractionary monetary policy slows the rate of growth in the money supply in order to control inflation, while sometimes this policy can slow 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:

The bank rate is also known as the discount rate. It is the rate of interest which the central bank charges on the loans and advances given to a commercial bank. When a commercial bank has a shortage of funds, they can borrow money from the central bank.

Borrowing of money by commercial banks is being done through the repo rate. If the repo rate is reduced, then the banks will get credit at a cheaper rate, and if the repo rate is increased, then the commercial banks have to borrow loans at an expensive rate. Fixation of bank rates is being done to control inflation and to maintain stability in the economy.

(ii) Open Market Operations:

Open market operations refer to the 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 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 commercial banks. Thus, open market operations are being done to make the bank rate policy effective.

(iii) Reserve Ratios:

The reserve ratio is also known as the 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 the 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 as a very important tool for controlling inflation and also a very important tool of monetary policy.

(iv) Selective Controls:

Selective control means to regulate the flow of credit for a particular purpose. The concept of selective control was opted by 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 on the prices of the commodities. The selective control method in India is being used in the 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 on the rise in prices of agricultural commodities and which are sensitive in nature. This scheme will be successful only when there is a variation in bank rate policy and reserve ratio.

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 the situation of depression was prevailing in the economy. Fiscal policy is related to 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 keeping a check and strict control of private spending. It also deals with various channels by which government spending on new goods and services entering the economy can directly add to aggregate demand and indirectly an addition to 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 a long and short-term basis.

Fiscal policy operates through two mechanisms: automatic stabilizers and discretionary action. Automatic stabilizers are government programs 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 a discretionary policy.

Direct Control:

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.

Role of Expectations in Economic 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 forms expectations about their future, whether consumers 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 walk of life, and every person uses them to form expectations.

Thus, expectations can be defined as a set of assumptions people make about what will happen in future. These assumptions serve as a guiding factor to individuals, businessmen and government in their day-to-day decision-making process. People used 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 additional staff for production purposes; 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 are 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 would 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 to predict 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 types of expectations prevailing in the economy, policymakers use to frame a suitable stabilization policy. The role of adaptive expectations is less while framing a stabilization policy because only past information is being taken into consideration, which can mislead 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 used to consider both past and present information while framing monetary or fiscal policy. If the government anticipates that inflation will occur in the near future, then the 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 many acres of land is being used by the farmer in the plantation of the agricultural commodity. If more land is being used by the farmer, it means more plants are being harvested so the prices will also be according to the plant harvested.

Role of Uncertainty in Economic Stabilization Policy

Uncertainty is one of the most important elements of Keynes’s theory of General employment. HM Minsky said that Keynes without uncertainty is like Hamlet without a prince (Minsky 1975 pg 57). GLS Shackle offered the same opinion when he declared that uncertainty is the very bedrock of Keynes’s 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 a 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 an uncertain environment, policymakers also face a lot of difficulty in making policy because policymakers do not know the precise value of multipliers. Each and every person is being affected by uncertainty, whether individuals, investors, government, businessmen, and policymakers.

Individuals 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 the 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 policymakers face a lot of difficulties while framing stabilization policy because of the uncertain economic environment. The government is always uncertain about how the economy will react to policy changes. Government and policymakers are not aware of the true structure of the economy, so they find a lot of difficulty while formulating a stabilization policy.

For example, if the government expects that inflation will increase in the near future, 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 prove to be true because of a 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, the government always works in a situation of fear and confusion, and any changes in the policy or any policy framed by the government will affect the economy. The government though uses various econometric models to study the effects of policy changes, but still, the effects will be seen in the economy because of the uncertain economic environment, and the government is not fully aware of the true model of the economy. If consumer expectations change, 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.

Policymakers can be wrong in framing a stabilization policy if the expectations of the consumers and individual changes in the near future. For example, it is very difficult to fix the price of oil, because prices of oil change 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 policymakers while framing the stabilization policy, and the economy has to face ups and downs due to the high level of uncertainty present in the economic system.

Role of Expectations and Uncertainty in Formulating Economic Stabilization Policy

Introduction

Types of Economic Stabilization Policy

Monetary Policy:

(i) Bank Rate Policy:

(ii) Open Market Operations:

(iii) Reserve Ratios:

(iv) Selective Controls:

Fiscal Policy:

Direct Control:

Role of Expectations in Economic Stabilization Policy

(a) Adaptive Expectations:

(b) Rational Expectations:

Role of Uncertainty in Economic Stabilization Policy

Read More in: Theory of Public Finance

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Introduction

Types of Economic Stabilization Policy

Monetary Policy:

(i) Bank Rate Policy:

(ii) Open Market Operations:

(iii) Reserve Ratios:

(iv) Selective Controls:

Fiscal Policy:

Direct Control:

Role of Expectations in Economic Stabilization Policy

(a) Adaptive Expectations:

(b) Rational Expectations:

Role of Uncertainty in Economic Stabilization Policy

Read More in: Theory of Public Finance

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