What Is Stabilization Policy?

Definition and Examples of Stabilization Policy

Central banks seek to minimize disturbances to economic growth and price stability by adjusting monetary policy. The two types of stabilization policy the Fed uses are expansionary monetary policy and contractionary monetary policy. Expansionary monetary policy provides stimulus for the economy when inflation is below the central bank’s stated goal and there is not full employment. Contractionary monetary policy restricts the economy if inflation climbs above a central bank’s stated goal.

During expansionary monetary policy, the Fed increases liquidity to encourage consumer spending and business lending. During contractionary monetary policy, on the other hand, the Federal Reserve decreases liquidity to cool the economy or slow lending, and prevent prices from rising too quickly.

How Stabilization Policy Works

Adjustments to monetary policy occur at periodic Federal Reserve Open Market Committee (FOMC) meetings. The FOMC consists of the Board of Governors of the Federal Reserve System, the president of the Federal Reserve Bank of New York, and four rotating presidents of the remaining Federal Reserve regional banks.

The FOMC meets eight times per year to review economic and financial conditions before changing monetary policy. After each meeting, the FOMC releases a public statement about its strategy for achieving its goals of maximum employment and price stability, otherwise called the Federal Reserve’s “dual mandate.”

Unlike the goal of maximum employment, the FOMC has affirmed that inflation of 2%, as measured by the price index for personal consumption expenditures, is its long-run goal for inflation. To meet this long-term objective, the FOMC pursues an average inflation rate of 2% over time, and will adjust monetary policy when it is persistently below 2% or moderately above that rate.

For years, price stability was the more important of the two goals, but there has been a recent shift to focus on maximum employment. In August 2020, the FOMC announced a new framework that calls for policy decisions to be informed by "assessments of the shortfalls of employment from its maximum level” due to the unemployment gap widening for many racial and ethnic groups during the pandemic.

When the FOMC agrees to alter monetary policy to stabilize the economy, it has a number of tools at its disposal, such as the discount rate, open market operations, and the reserve requirement. Open market operations have been the primary tool for adjusting monetary policy due to the flexibility of the approach. Open market operations are the buying and selling of securities between banks and the Federal Reserve. When the Fed conducts open market operations, the federal funds rate can change.

For example, when the Fed conducts expansionary monetary policy and lowers the fed funds target rate, this spurs economic activity. Lowering the federal funds rate results in lower consumer loan and mortgage interest rates, which encourage household spending. Businesses also commit to investment projects when there are reduced financing costs, which can lead to higher profits and more hiring.

When the Fed conducts contractionary monetary policy and increases the federal funds rate, however, consumer and business spending will slow due to higher borrowing costs. Consumers also save more with higher interest rates in place, which reduces the money supply and lowers inflation.

In addition, the FOMC in recent years has created tools such as reverse repurchase agreements or “repos,” and large purchases of mortgage-backed securities to help its stabilization policy work.

What It Means for Individuals

Expansionary fiscal policy is generally used to boost gross domestic product (GDP) growth and the indicators that tend to move with GDP, such as employment and individual incomes, so it can lead to more jobs and higher wages for ordinary people. However, this type of fiscal policy also tends to have undesirable effects on interest rates and investments, as well as exchange and inflation rates that are experienced by households and businesses, so persistent fiscal stimulus becomes less effective over time.

Contractionary fiscal policy, on the other hand, may be used to slow economic activity but can have a detrimental effect on individuals’ livelihoods and everyday expenses as hiring tightens and rates rise. It may also cause a recession.