Growth vs Stability is one of the basic trade-offs in the economy, which shows that if we are focused on growth, it threatens stability, and being focused only on stability is costly for economic growth. For example, if our focus is on higher economic growth, then we use the expansionary fiscal and monetary policy, which increases the aggregate demand and creates inflationary pressure in the economy. These threats to overall macroeconomic stability.
Similarly, if our focus is on stability only, then the economy has to compromise with economic growth. For example, to stabilize the economy through price control during an inflationary situation. The macro policies are contractionary, which discourages investment and economic growth. This shows the trade-offs between growth and stabilization.
Economic growth is a long-term concept that demands long-term investment and capital formation to enhance the supply capacity of the economy, and the growth is a continuous process. However, stability is a short-term concept where the stabilization policies for maintaining stability are the short-term demand management policy. So, the stabilization policy regulates the aggregate demand to maintain AD = AS, where if AD>AS, there is inflationary pressure, and if AD < AS, then it leads to recession and ultimately to depressionary pressure in the economy. Both of them are said to be unstable in the economy.
However, growth policies are long-term supply enhancement policies that aim to increase the aggregate supply (AS) by increasing productive investment in the economy. So, the growth policies are structural reform policies that make reform to attract investment, capital formation, and growth.
The trade-off between growth and stability is only in the short run, but in the long run, they are complements to each other. For example, a certain degree of stability is necessary to attract private investment and support for higher economic growth and employment. In the situation of higher instability, investment is discouraged and minimizes the growth potential.
Similarly, the higher investment and growth increase the aggregate demand in the long run, which helps to maintain stability by increasing aggregate demand when aggregate supply is also increasing in the long run.
This shows that we should balance the macro policy to maintain growth and stability simultaneously. For example, the fiscal policy is more growth-oriented, and the monetary policy is more focused on stability. So, both the fiscal and monetary policies should be designed in such a way that the objective of growth and stability can be achieved.
Here, OYf is the full employment level of output in the given period. As the objective is to maintain a full employment equilibrium, the desired output/optimum price level is P* and aggregate demand is AD*. If the aggregate demand is AD1 < AD*, there is a shortage of aggregate demand by Y1Yf, or there is excess capacity of the economy. This discourages the investment and slows the growth, and the economy falls into recession. So, the expansionary policies are to be used to increase the aggregate demand from AD1 to AD*, and the economy stabilizes at E* with a full employment level of output and an optimum price level of P*.
Similarly, if the aggregate demand is AD2, then there is excess demand by YfY2 in the economy, which drives the price level upward and creates an inflationary situation. So, the contractionary policy is used to reduce aggregate demand from AD2 to AD* and the economy is stabilized at E* with the optimum price level P* and full-employment level of output.