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Economic stability is the absence of excessive fluctuations in the macroeconomy. An economy with fairly constant output growth and low and stable inflation would be considered economically stable. An economy with frequent large recessions, a pronounced business cycle, very high or variable inflation, or frequent financial crises would be considered economically unstable.
Real macroeconomic output can be decomposed into a trend and a cyclical part, where the variance of the cyclical series derived from the filtering technique (e.g., the band-pass filter, or the most commonly used Hodrick–Prescott filter) serves as the primary measure of departure from economic stability.
A simple method of decomposition involves regressing real output on the variable “time”, or on a polynomial in the time variable, and labeling the predicted levels of output as the trend and the residuals as the cyclical portion. Another approach is to model real output as difference stationary with drift, with the drift component being the trend.
Causes of instability
John Maynard Keynes believed, and subsequent Keynesians believe, that unstable aggregate demand leads to macroeconomic instability, while real business cycle theorists believe that fluctuations in aggregate supply drive business cycles.
Effects of instability
When a stabilization policy is implemented, it generally involves the use of either monetary policy or fiscal policy. Either of these may be advocated by Keynesian economists. However, they are generally opposed by monetarists and real business cycle theorists. Monetarists believe that well-intentioned contercyclical monetary policy will generally be counterproductive, adding to the existing variability of real output, and real business cycle theorists believe that such policies are misguided because they do not address the underlying causes of fluctuations, which they believe lie on the supply side of the economy.