How to keep an economy stable using policy tools

Why in the News

Macroeconomic stabilisation has moved from John Maynard Keynes‘s assumed straight line links between economic variables to policy built on how households and firms actually behave. The Royal Swedish Academy of Sciences has awarded the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2026 to Robert E Hall of Stanford University and Michael Woodford of Columbia University, “for microeconomic foundations of macroeconomic stabilisation“.

What is macroeconomic stabilisation?

1. What it is: Macroeconomic stabilisation means the policies governments and central banks use to smooth booms and slumps. It works like a thermostat, cooling an overheating economy and warming a slowing one.
2. Inflation fight: The Reserve Bank of India (RBI) raised interest rates last week to contain inflation. Prices had risen after the war between the United States (US) and Iran and the Strait of Hormuz blockade lifted crude and commodity costs.
3. Recovery support: In the years around the Covid-19 pandemic, the Union government cut direct taxes and the Goods and Services Tax (GST), and the RBI cut interest rates, to boost consumption and investment.
4. Cost of doing nothing: Without intervention, inflation can soar and people cut all but essential spending. Many businesses then fail, jobs are lost and recovery takes much longer.
5. The takeaway: Stabilisation policy decides whether a price or demand shock passes quickly or turns into years of lost jobs and output, which is why the economics behind it earned the prize.

How did stabilisation policy rise and fall?

1. Great Depression: A stock market crash in October 1929 began the Great Depression in the US. Thousands of banks and businesses failed, and the crisis spread to Europe.
2. Scale of the slump: US gross domestic product (GDP), the value of annual output, fell by 30% and the unemployment rate soared to 25%.
3. Laissez faire: The ruling view of the time held that governments should not intervene in the economy.
4. Keynes’s remedy: In a slowdown, policymakers should cut rates and taxes and spend more, even on a budget deficit. They should raise rates when the economy overheats.
5. Stagflation: In the 1970s, repeated oil price shocks brought high inflation and high unemployment together. Boosting growth spiked inflation and fighting inflation worsened unemployment, so Keynesian policy came to be seen as the problem.

What did Hall and Woodford add?

1. Grounded in data: From the late 1970s, the two rebuilt the Keynesian approach on research. Keynes had assumed linear links, such as between inflation and unemployment; they studied ground level data instead.
2. Hall, the demand side: Hall studied how people decide how much to consume, and when they raise or cut spending, using household data.
3. Hand to mouth households: In 1982, Hall used microdata on individual households to show that not everyone raises spending when they expect higher income. Hand to mouth households, which spend what they earn, do not.
4. Woodford, the supply side: Firms do not change prices every day, and they look to the future when fixing them. So expectations about future interest rates shape today’s inflation.

Why does their work matter for policy today?

1. Forward guidance: Woodford’s finding means central banks must clearly convey what they intend to do, because firms set prices on that basis. This practice is known as forward guidance.
2. Evidence based policy: Hall’s household level evidence on who changes spending, and when, has informed policy choices on supporting consumption.
3. Resilience to shocks: A pandemic, wars that spiked commodity prices and policy missteps such as tariffs have hit the world economy. Growth has still surprised on the upside, partly because policy draws on such work.

Conclusion

Stabilisation policy now rests on evidence about how real households and firms behave rather than on assumed relationships, which has made a central bank’s communication a policy tool in its own right. How clearly the RBI signals its path as it fights oil driven inflation is a live test of that insight in India.

Back2Basics: Sveriges Riksbank Prize in Economic Sciences

1. Origin: Sveriges Riksbank, Sweden’s central bank, instituted the prize in 1968 to mark its 300th anniversary. It is not one of the five prizes in Alfred Nobel’s will.
2. Award: The Royal Swedish Academy of Sciences selects the laureates. The first prize, in 1969, went to Ragnar Frisch and Jan Tinbergen.
3. Indian laureates: Amartya Sen won in 1998, and Abhijit Banerjee in 2019, with Esther Duflo and Michael Kremer.
4. Prize money: This year’s laureates share 12 million Swedish kronor, about Rs 12 crore.

Matching Previous Year Question

“[2026] ‘X’, born in the UK, was conferred the Nobel Prize in 2025. He was a professor in an American university when the prize was announced. Identify ‘X’: (a) Michel H. Devoret (b) Richard Robson (c) John Clarke (d) Joel Mokyr ANSWER: C”