16 - Stabilisation policy in a closed economy

Summary

Recommendations for stabilising aggregate production and employment have usually been derived from the analysis of multiplier models, using the method of comparative statics. This type of analysis does not provide a very firm basis for policy recommendations, for two reasons. First, the time path of income, production and employment during the process of adjustment is not revealed. It is quite possible that certain types of policy may give rise to undesired fluctuations, or even cause a previously stable system to become unstable, although the final equilibrium position as shown by a static analysis appears to be quite satisfactory. Second, the effects of variations in prices and interest rates cannot be dealt with adequately with the simple multiplier models which usually form the basis of the analysis.

In section I of this chapter the usual assumption of constant prices and interest rates is retained, and a process analysis is used to illustrate some general principles of stabilisation policies. In section II these principles are used in developing and analysing a more general model, in which prices and interest rates are flexible.

Some general principles of stabilization

The model

The model consists of only two relationships. On the supply side, it is assumed that the rate of flow of current production, measured in real units per year and identical with the flow of real income, is adjusted, after a time lag, to the rate of flow of aggregate demand, also measured in real units per year.