Economic stability enables other macro-economic objectives to be achieved, such as stable prices and stable and sustainable growth. It also creates the right environment for job creation and a balance of payments. This is largely because stability creates certainty and confidence and this encourages investment in technology and human capital.
Unfortunately, an unintended consequence of globalisation is the increased likelihood of economic shocks, including supply side shocks like oil and commodity price shocks, and demand side shocks like the credit crunch.
Built-in automatic fiscal stabilisers, which include progressive taxes and escalating welfare payments, provide a shock absorber to stabilise an economy following an economic shock. The combined effect of these is to create fiscal drag during periods of unusually strong growth, and fiscal boost during periods of very weak growth or negative growth. Negative or positive demand side shocks can be stabilised more quickly when automatic stabilisers are built-in to the tax-benefit system.
Floating exchange rates are also seen as an automatic stabiliser. In the event of either a negative demand or supply side shock affecting an economy, the exchange rate will fall as currency traders sell the currency, leading to a fall in export prices and an automatic increase in competitiveness. Assuming foreign demand is price elastic, export revenue will rise, and, via an upward multiplier effect, aggregate demand will bounce back.
The third automatic stabiliser is flexible labour markets. In the events of a demand side shock, like the credit crunch, aggregate demand will fall and firms will experience a fall in demand for their products. If the labour market is inflexible, full-time workers may be made redundant, and their spending will fall. Assuming a downward multiplier effect, national income will fall further, and the economy may plunge into a recession. However, with a more flexible labour market, a number of flexible responses can occur, which stabilise the economy. For example, instead of making workers redundant, pay can be reduced so that unemployment is avoided. In addition, full-time workers can go part-time, again avoiding full-blown unemployment. Finally, a more flexible and mobile workforce can move quickly from areas or industries with low demand to areas or industries with higher demand.
In addition to these automatic stabilisers, short-term stability can be maintained by altering monetary conditions, such as raising or lowering interest rates, or by expanding or contracting the money supply. Most national economies and monetary unions review monetary policy on an ongoing monthly basis.
More on monetary policies
Sustainable economic growth occurs because of increases in aggregate demand and supply. However, long-term sustainable growth ultimately depends on supply-side improvements because balance of payments and inflationary problems are less likely when the productivity of factors improves. Policies to promote growth include:
Technology policy refers to policies where government provides incentives for private firms to invest into new technology. These incentives could be in the form of grants, cheap loans, or tax relief.
Investment in human capital by allocating more resources to education and training is widely regarded at critical to the success of developing and developed economies. Human capital development provides key skills and knowledge to enable increases in productivity and efficiency.
A key driver of growth for both developed and developing countries is FDI, and this can be encouraged by reducing red tape and unnecessary regulation, and opening up markets to overseas investors.
National governments can provide incentives for individuals to start their own business and for small businesses to expand.
Redesigning the tax and benefit system to increase the labour activity rate and encourage work and discourage idleness is clearly an important option for countries wishing to improve their supply-side performance.
Another important stimulus to supply-side growth is to increase the degree of competitiveness in the micro-economy by promoting contestability, reducing barriers to entry, and by deregulating markets to encourage new entrants.
Sustainability can also be achieved by encouraging the formation of new markets which exploit new technology or new trading methods. The newly emerging markets for waste and carbon credits, and the development of carbon offsetting schemes, are recent examples of how new markets can emerge, with or without government support.
Long-term development of infrastructure projects is also central to the promotion of long terms growth and development in a globalised environment. Better infrastructure enables output to be transported at lower cost, as well as generating jobs and other positive externalities.