Economic stabilization policies. Is the policy ideology trustworthy?
The macroeconomic slogan played nowadays by all policymaking authorities in Sri Lanka is that the economy has now been stabilised from the bankruptcy/crisis confronted in 2022 and, therefore, the stage is set for sustainable growth momentum in future. This story is common for all countries who suffered the same economic crisis in 2022 akin to the global corona pandemic. Skyrocketing of inflation, exchange rate and balance of payment deficit, the difficulty in public debt service and grave shortage of essential commodities were the major crisis outcomes.
The stabilization story entails raising interest rates and taxes and cutting fiscal spending and deficits on the tune of the IMF bailout package. These are the standard stabilization policy actions faithfully pursued around the world whenever countries confront such difficult economic situations which are known as economic instabilities. Such policy actions known as monetary and fiscal policies are the cruel conditionalities imposed in IMF-World Bank programmes when countries approach them for stabilization assistance.
However, national leaders and frontline economists who praise the IMF and policymakers for such stabilization service do not seem to fully understand the macroeconomic ideology behind the stabilization policies and its fundamental fallacies in the real world.
Therefore, this article contains two parts. First, how the ideology has evolved from the classical economic equilibrium model to different variants at present is highlighted below in this article. The second part on the fallacies of the ideology will be presented in the next article.
Classical equilibrium model - Supply creates its own demand and determines the size of the economy and livings standards
Accordingly, economic instabilities are cited as the situations of mismatches between the national income and national expenditure. Therefore, stabilization policy actions are intended to adjust the expenditure side of the equation to bring the equilibrium back to the economy. The income side of the equation is termed as the aggregate supply or supply side of the economy representing the production activities. The equation's expenditure side is the aggregate demand or demand side of the economy that represents the utilization of the production. Both sides are the flows of the supply of and demand for the aggregate production.
However, the stabilization policy ideology entirely rests on the assumption that the supply side of the economy is externally determined outside the policy actions whereas only the demand side is responsive to policy actions. This rude assumption is the bread and butter of almost all mainstream economists talking of monetary and fiscal policies for stabilization of economies through the demand side management.
Accordingly, stabilization policy actions are chosen on a set of benchmark economic numbers such as inflation rate, economic growth and unemployment rate. In addition, a host of other numbers such as interest rate, exchange rate, foreign currency reserve and fiscal revenue, deficit and debt ratios is also fixed to show the ongoing progress of the stabilization policy package. Developed countries also use the same demand management policy ideology to deal with business cycles, i.e., cyclical trend of economic booms and downturns, which are treated as macroeconomic disequilibria. Several noble prize wining mathematical models also have been created on the same stabilization ideology with different variants. However, the blunt root of the stabilisation policy ideology is the old classical interpretation of the link between the real production and its utilization in the economy.
In this model, the production is shared as incomes among the factors of production, i.e., land, labour, capital and entrepreneur, as rent, wages, interest and profit where such incomes in turn are utilized to buy the production for consumption and investment purposes. Therefore, the supply creates its own demand and drives economic development and living standards. Accordingly, capacity, efficiency and employment of factors of production determine the level of income, growth and living standards. Therefore, changes in the production are the sources of instabilities of the economy confronted from time to time causing in changes in employment, income and livings standards. The model believed an automatic market process to stabilize the economy at a new level.
However, the demand side was later developed by neoclassical economists to explain the behaviour of the demand side on individuals through consumption and savings based on concepts such as the utility maximization theory. However, the economy is always in equilibrium, i.e., the supply and demand in aggregates are equal, although individuals may behave differently in their decisions on supply and demand.
This classical ideology was a real quantity model as there was no externally produced money or currency in old economies because selected commodities that were used as moneys were a part of the existing production. Therefore, the model did not define a concept of general price level or inflation based on values measured by one specific kind of money. As the model was a real quantity model, it contained only relative prices between products used in exchange transactions.
For example, if rice was used as a type of money, the price of dried fish depended on the flow of the supply of rice to buy the dried fish. Therefore, if the demand for dried fish rose compared to the supply of rice, the relative price of dried fish also rose indicating the value of rice money falling/depreciating compared to dried fish. However, the value of rice money could rise in relation to some other products if the flow of rice money declined for those products.
University economics professors have developed this classical national income identity model to explain how economies behave in real terms of the production and its utilization. It is this model that has later led to the demand management ideology-based stabilization policies.
Demand management model - Demand creates the supply and stability of the economy
This can be understood from the national income identity as summarised below.
- Production or GDP = Expenditure on GDP or Y = E
The economy operates with the private sector and government. While the private sector is engaged in the production, both the private sector and government utilise the same production. The government levies taxes (T) from the private sector's income and spends (G) tax proceeds (T) for public order and safety. The private sector's expenditure is consumption (C) and investments (I) where investment is financed by savings (S) of production (as there is no externally created monetary credit to fund investment). In open economies, export (X) made out of production is not available for domestic expenditure while import (M) (made out of production of other countries) is added to the domestic expenditure. Therefore, the expenditure on Y or domestic production is equal to Y only if X is added to and M is subtracted from the domestic expenditure.
Accordingly, the GDP identity in open economies is as follows.
- Y = C+I+G+X-M ............ (1)
The right hand side is the demand side of the economy with a breakup of private sector (C+I), state sector (G financed by T) and foreign sector balance (X-M or trade balance). This is the crust of the demand management policy ideology. This shows that any change in the components of the expenditure compared to the level of domestic production can cause disequilibrium or economic instability, which is the mismatch between aggregate demand and aggregate supply.
Therefore, if the aggregate supply is beyond the control of policymakers, any disequilibrium of the economy has to be resolved through the adjustment of the components of the demand side to match the supply side. How the aggregate demand is adjusted depends on the policy actions adopted, provided that the demand is responsive to such policy actions. This is the ideology used for the demand management for economic stabilization.
However, no stabilization managers seem to dig into the structure of supply side (Y) and demand side (E) and policy mix necessary to improve living standards. Instead, they simply assume that the supply side is beyond the control and only demand side is controllable without worrying of its composition and side effects. Further, these ideologists have no realistic measurements to know the aggregate supply, aggregate demand and causal factors to gauge the exact size of policy actions required and their spill-overs.
Monetarist model - Money determines the demand, instabilities and living standards
The school of monetarists also lives on the demand side of the classical equation by introducing the money (MS) (fiat currency) and general price level (P) into it. The P is the exchange rate between the total production and the total stock of fiat money in circulation. It shows how many units of money are worth one unit of production in the economy. For example, If the economy produces 100 units while the stock of money supply is 400 units, the P of the production is 4 units of money in average.
Therefore, if the money supply later increases to 500 units while the production remains same, the P increases to 5. This means an inflation rate of (the increase of P) 25%. This blind ideology is the monetarists' root of inflation which is believed to be always everywhere a monetary phenomenon. Milton Friedman is the monetary god behind this belief.
It is this ideology that has been used by economists and politicians to frighten the general public across the world that the inflation is the state of too much money chasing after too little production. This ideology has helped central banks around the world to enjoy independence from the public behind the inflation screen on the belief that they only can control inflation around the world because the money supply is totally at their hands.
The monetary ideology is utterly simple. As the demand for goods and services is priced and made through money, any new money added to the circulation increases the buying power in the economy. Accordingly, this increased buying power causes the aggregate demand to exceed the prevailing aggregate supply in the economy. Therefore, the general price level will increase to keep the aggregate demand equal to the existing aggregate supply. This is the inflation. The opposite is the deflation.
Both situations are labelled as economic instabilities or imbalances between the aggregate demand and aggregate supply. Therefore, whenever any inflationary or deflationary situation is reported, the monetarists' blind prescription is to change the level of money supply to affect the aggregate demand. Accordingly, the refined monetary formula for keeping the economic stabilization is to control the supply of money at a rate of its growth equal to the sum of the expected GDP growth target and inflation target. This policy is fashionably known as flexible inflation targeting monetary policy.
However, monetarists don't have undebatable measurements of money stock, inflation, causal factors and targets to assess the effectiveness of such monetary policy actions.
Demand side's sectoral imbalances - Fiscal imbalances cause private sector imbalances and economic instabilities
Modern mainstream economists use the same classical model to understand how the private sector and government cause economic instabilities. The major assumption made here is that domestic production is the result of the private sector whereas the government is engaged in only redistributing it through taxes and expenditure for better or fair level of public welfare. This gives a revised version of demand management ideology fondly followed by mainstream economists of all corners around the world.
This version is derived by looking at how the private sector utilises its production or factor income. It is the payment of tax (T), consumption (C) and savings (S). The income of the government is the T (tax revenue) which is used for financing its expenditure known as public.
- Y = T+C+S ................. (2)
As both Y equations (1) and (2) above are equal because both represent the same production from two lenses, a new macroeconomic equilibrium statement is derived to identify the sectoral economic imbalances on the demand side that can cause economic instabilities as follows.
- T+C+S = C+I+G+X-M
- (G-T) = (S-I) + (M-X)
- Budget Deficit = Private Sector Savings Surplus + Foreign Trade Deficit
This is the ideology bluntly used by modern demand management economists to present fiscal deficit and debt. This shows that if the government runs fiscal deficits, the private sector has to run a savings surplus (or crowd out investments) and a foreign trade deficit in order for the government to mobilize or borrow resources to finance its deficits. Therefore, the continued fiscal deficits and resulting accumulation of debt are singularly blamed for deficits in private investment and balance of payments.
This ideology is largely applicable for economies with money treated as external to the government where the government also has to borrow from the private sector if it wishes to spend more than the tax revenue (fiscal deficits). Monetarists find the fiscal deficit and debt as the single culprit for excess demand and inflation. However, in the classical real economy model, there are no fiscal deficits and moneys as government expenditure is financed by real taxes levied from the existing production of the private sector.
Accordingly, this demand management-based stabilization ideology has been under extensive research and application through various models. The Keynesian model, economic development model and neoliberal model are the most popular models.
Keynesian fiscal multiplier model - Fiscal deficit expansion solves unemployment and supply side recessions
The Keynesian model emerged as the solution to the Great Depression confronted by western economies in 1930s. The Great Depression constituted a decline in production, employment, income and demand. Therefore, Keynesian prescription was to create new employment opportunities directly through the increased fiscal deficit spending financed by the creation of new debt/money so that the new wage income generated by fiscal deficits could stimulate the aggregate demand and aggregate supply through multiplier effects.
This model focuses on the faster growth and development or supply side through the expansion of the demand side by fiscal deficit spending. Therefore, the present state of development of both developed and developing countries is a direct result of the application of the Keynesian model. This model is popularly used to recover economies from recessions and downturns.
Economic development models - How savings and investments in the demand side should be mobilized to promote the growth and living standards
This model has been focused on demand side structural problems of under-developed countries that keep them in poverty cycles. Therefore, these models prescribe external mobilization of savings and investment for enhancement of growth and employment for the development. Export-led growth model pursued by the developing world is a result of these development models.
Eminent economists such as Amartya Sen have presented economic development-based public welfare models that provide for people's freedom of choice and enlarging capabilities through the development.
Neoliberal free market trickle-down model - Small government and private market mechanism with external money promote growth, stability and living standards
The neoliberal model has emerged since 1970s based on the monetarists' inflation ideology stated above. The model has been marketed by Milton Friedman, Washington Consensus and IMF-World Bank group. Its focus is the small government by cutting fiscal spending, debt, taxes and market regulations. This is to facilitate the private sector to operate competitively as the engine of the economy whereas the central bank independently controls the money supply to preserve the price stability as the foundation of economic stability and growth. Therefore, this model focuses on market-based economies with small governments.
Modern complex mathematical models - Mathematics shows effectiveness of monetary and fiscal policies to stabilize the demand side
Modern research contains a lot of mathematics-based economic models carried out by leading university professors wining Nobel prizes to explain the results and constraints of the demand management stabilization model. The latest model is labelled as "microeconomic foundations of macroeconomic stabilization" wining the 2026 Nobel prize by Robert E. Hall and Michael Woodford.
Their research reveals how stabilization policies and their effectiveness are influenced by economic behaviours of individuals and businesses although monetary and fiscal policies target macro-level economic outcomes for the economic stability and stabilization. All such research models are nothing but mathematical models on the same demand management ideology with more and more fictitious assumptions.
Concluding remarks
- Models highlighted above show how modern demand management ideology has evolved from the classical real supply side to monetary-based demand side for stabilization of economies to keep the demand appropriate to the supply. Therefore, present demand management policies are intended to stabilize market prices through monetary operations (such as interest rates, exchange rates, commodity prices and fiscal debt) at desirable targets considered as stabilization rather than managing the real output and resources to target the livings standards in democratic societies.
- However, real world experiences are such that demand management-based stabilization ideology has failed to keep the so-called macroeconomic stability of both developed countries and developing countries although the ideological network has globally spread globally through several schools of economists. IMF-World Bank stabilization programmes prescribed in neoliberal models for decades have failed to stabilize or improve living standards of developing countries although the programmed set of stability numbers is artificially achieved.
- This is the frontline concern raised against economic stability policy model followed in Sri Lanka whose 17th IMF programme is due to complete in March 2027 without any stability of the real economy despite the demand side's rosy numbers whereas 18th IMF programme is seen unavoidable.
- It is noted that almost all economists promoting the demand management ideology are mostly mathematical economists who have no field experience in implementing of public economic welfare policies.
- Therefore, it is the common economic sense that the demand stabilization ideology has miserably failed despite its fondly narratives and slogans.
Therefore, the next article is planned to reveal fundamental fallacies of the ideology and structural risks and bottlenecks created by them in the supply side and living standards in modern state currency-based monetary economies.
(This article is released in the interest of participating in the professional dialogue to find solutions to present economic policy and system problems confronted by the general public. All contents in the article are based on the author's research and views on the specific subject which have no intension to personally discredit characters or ideologies of any individuals.)
P Samarasiri
BA Hons Economics (University of Colombo, Sri Lanka), MA Economics (University of Kansas, USA)
(35 years of experience in staff class in the Central Bank, inclusive of Director of Bank Supervision, Assistant Governor, Secretary to the Monetary Board and Compliance Officer of the Central Bank, Chairman of the Sri Lanka Accounting and Auditing Standards Board and Credit Information Bureau, Chairman and Vice Chairman of the Institute of Bankers of Sri Lanka, Member of the Securities and Exchange Commission and Insurance Regulatory Commission and the Author of 13 Economics and Banking Books and a large number of articles published.)
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