Does Economic Stability Contribute To Growth?

During the period 1920 to 1960, we can observe that the annual growth rate of production was more volatile than between the period 1961 to February 2019. During the first period, the maximum growth rate stood at 62% and the minimum growth rate at minus 33.7%. Between 1961 to present, the maximum growth rate stood at 13.4% and the minimum growth rate at minus 15.3%, (see chart). One is tempted to conclude from this that this raises the likelihood that fiscal and monetary policies are currently more successful than in the past in stabilizing the economy.

For most economic experts the role of central authorities is to make the so-called economy as stable as possible. What do they mean by economic stability?

Economic stability refers to an absence of excessive fluctuations in the overall economy. An economy with constant output growth and low and stable price inflation is likely to be regarded as stable. An economy with frequent boom-bust cycles and variable price inflation would be considered as unstable.

According to popular thinking, stable economic environments in terms of stable price inflation and stable output growth acts as a buffer against various shocks. This makes it much easier for businesses to plan. In this way of thinking in particular, price level stability is the key for so-called economic stability.

For instance, let us say that a relative strengthening in people’s demand for potatoes versus tomatoes took place. This relative strengthening is going to be depicted by the relative increase in the prices of potatoes versus tomatoes.

Now to be successful, businesses must pay attention to consumers’ wishes as manifested by changes in the relative prices of goods and services. Failing to abide by consumers’ wishes will lead to the wrong production mix of goods and services and will lead to losses.

Hence, in our case, by paying attention to relative changes in prices, businesses are likely to increase the production of potatoes versus tomatoes.

On this way of thinking, if the price level is not stable then the visibility of the relative price changes becomes blurred and consequently, businesses cannot ascertain the relative changes in the demand for goods and services and make correct production decisions.

This leads to a misallocation of resources and to the weakening of economic fundamentals. Unstable changes in the price level obscure changes in the relative prices of goods and services. Consequently, businesses will find it difficult to recognize a change in relative prices when the price level is unstable.

Based on this way of thinking it is not surprising that the mandate of the central bank is to pursue policies that will bring price stability i.e. a stable price level.

The Contradiction Inherent in Fed Efforts to Stabilize Prices

By means of various quantitative methods, the Fed’s economists have established that at present policymakers must aim at keeping price inflation at 2%. Any significant deviation from this figure constitutes a deviation from the growth path of price stability.

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Moon Kil Woong 10 months ago Contributor's comment

They want low inflation because countries are running massive deficits and the central banks have a tremendous amount of debt to keep floating.

Norman Mogil 10 months ago Contributor's comment

Governments would like higher, not lower inflation. Higher inflation means greater tax revenues--- taxes are based on nominal income, not real income. So, higher inflation would reduce deficits.

Duke Peters 10 months ago Member's comment

*Hand on face*, Of course you are right. Thanks.

Moon Kil Woong 10 months ago Contributor's comment

Usually that is the case. However if debt becomes to enormous then inflation could cause bond payments to exceed tax increases when inflation rises. Certainly a government that cuts taxes and has massive debts might not want rates to rise because the tax increases may not offset the interest rate payments.

Terrence Howard 10 months ago Member's comment

Good point as always.

Duke Peters 10 months ago Member's comment

Doesn't everyone want low inflation? Why would someone want high inflation?