In this lesson summary review and remind yourself of the key terms and graphs related to automatic stabilizers, including the different kinds of automatic stabilizers and why fiscal policy is subject to lags.
Lesson Summary
Are the lags, or delays, in discretionary fiscal policy frustrating you? Don't worry, if lags are causing policymakers to be slow to act, automatic stabilizers will help in the meantime.
In a previous lesson, we learned that policymakers can use discretionary fiscal policy as a tool to end recessions or inflationary booms. But delays in putting those plans in place are common, and may even destabilize an economy even more. Luckily, there are mechanisms in place called automatic stabilizers. These mechanisms will kick in immediately to soften the swings of the business cycle, even if policymakers can't act quickly.
Automatic stabilizers are tools built into federal budgets that reduce the impact of the business cycle. They are “automatic” because they happen without requiring anyone to take any action. When aggregate demand decreases, two actions kick in automatically. First, income taxes will go down because the amount of income has decreased. At the same time, transfer payments like unemployment compensation and welfare benefits will increase. As a result, consumption will not decrease by as much as it would have.
Key Terms
| Key term | definition |
|---|
| discretionary fiscal policy | a fiscal policy action that requires a deliberate act, such as passing a spending bill or a tax plan |
| automatic stabilizers | fiscal policy actions that require no action and will occur automatically based on the current phase of the business cycle; the most common automatic stabilizers are progressive tax systems and transfer payments. |
| progressive tax system | a way of taxing that has higher tax rates at higher levels of income; for example, Holly makes per year and pays in income taxes, but Nasrin makes per year and pays in income taxes. |
| disposable income | the amount of income left over after taxes are deducted; if you make per week, but in taxes are deducted, you have in disposable income that you can actually spend. |
| transfer payments | (sometimes called income supports) payments that received without the exchange of a good or service, such as welfare payments or unemployment compensation; when people lose jobs during recessions, unemployment compensation will mean that consumption will not decrease by as much. |
Key takeaways
Automatic stabilizers support the economy during downturns and prevent overheating during booms
Automatic stabilizers might not smooth out the business cycle completely, but they do make the swings of the business cycle less extreme. Automatic stabilizers are any part of the government budget that offsets fluctuations in aggregate demand. They offset fluctuations in demand by reducing taxes and increasing government spending during a recession, and they do the opposite in expansion.
Taxes are automatic stabilizers
Taxes work as an automatic stabilizer by increasing disposable income in downturns and decreasing disposable income during booms.
Let's think about this at the individual level. Suppose you make per week and pay in income taxes, so you have to pay in taxes and have to spend. All of a sudden there is a serious recession.
The bad news is your pay got cut in half, so now you only make per week. The good news is that your take-home pay did not get cut in half! It turns out that you live with a progressive tax system, so when your pay got cut, your tax rate fell to . So instead of your disposable income falling to , it only falls to .
The same concept works in reverse. Suppose there is a positive shock to aggregate demand, and you get a bonus. However, that pushes you to a higher tax rate of , so even though your paycheck doubles, your take-home pay does not.
Government policies and institutions can act as automatic stabilizers
Many countries have government agencies that help out when people are out of work, such as welfare payments or unemployment compensation. Spending on these programs increase during recessions and decrease during expansions. That spending isn't directly part of GDP (remember that transfer payments do not count in the government spending component). However, spending on programs like these does have an indirect effect on GDP through consumption.
Suppose you lose your per week salary because you lose your job. Without unemployment compensation, your spending might fall dramatically, which would lower the consumption part of GDP. However, if it turns out that you can get per week in unemployment benefits, your consumption would not fall as dramatically.
Automatic stabilizers can cause budget deficits during downturns and surpluses during expansions
Imagine two countries that have the same tax revenues and government spending.
Salvania starts out in long-run equilibrium and a balanced budget, with million in government outlays paid for with million in tax revenues collected every year. Suddenly, the stock market crashes in Salvania causing widespread panic and decreased consumption. Luckily, the automatic stabilizers kick-in. Tax revenues decrease to million, while the government is now paying for million in government spending and transfer payments. Salvania is now facing a budget deficit of million.
On the other hand, Nadyaland’s long-run equilibrium is interrupted by a boom. When the automatic stabilizers kick in, tax revenues increase to million and spending falls to million. As a result of the stabilizers, Nadyaland has a budget surplus of million.
In the real world, there are a lot of other reasons that a country might run a budget deficit or a budget surplus. But, automatic stabilizers contribute to those deficits and surpluses too. For example, the United States was in a recession during 1982. That year it ran a deficit of around billion. But if you remove the effect of automatic stabilizers that had kicked in, the deficit was actually only billion. Similarly, during the expansion in 1999, the United States had a budget surplus of around billion, but if you remove the effect of automatic stabilizers, the surplus was actually around billion.
Common misperceptions
Discretionary fiscal policy and automatic stabilizers are frequently confused with each other. If a government has to take any action to make it happen, it is discretionary fiscal policy. If it is something that happens on its own, it is an automatic stabilizer.
Some students think transfer payments are in the “G” category (“government spending") of aggregate demand, but this is not correct. Transfer payments and tax rebates do not count directly in real GDP. They impact real GDP indirectly through their effect on consumption. When Holly gets a tax rebate from the government, it is not counted as government spending because the government is not buying anything from her. But when she spends that money on veggie burgers and baseball gear, it gets counted in consumption.
Discussion questions
- Which of the fiscal policy lags do automatic stabilizers avoid? Explain.
- Describe the process by which automatic stabilizers would reduce output in an positive output gap.
- How do transfer payments show up in aggregate demand if they are not a part of government spending?
FAQs
Automatic stabilizers are features of the tax and transfer systems that temper the economy when it overheats and stimulate the economy when it slumps, without direct intervention by policymakers. Automatic stabilizers offset fluctuations in economic activity without direct intervention by policymakers.
What are automatic stabilizers changes in ______? ›
Automatic stabilizers are any part of the government budget that offsets fluctuations in aggregate demand. They offset fluctuations in demand by reducing taxes and increasing government spending during a recession, and they do the opposite in expansion.
What is the primary benefit of the automatic stabilizers group of answer choices? ›
The primary benefit of the automatic stabilizers is:Group of answer choicesthey provide public assistance through legislative decision making. they require no new legislative action, so there is no legislative lag before these tools respond to fluctuations in the business cycle.
What are two examples of automatic stabilizers more than one correct answer? ›
The best-known automatic stabilizers are progressively graduated corporate and personal income taxes, and transfer systems such as unemployment insurance and welfare. Automatic stabilizers are called this because they act to stabilize economic cycles and are automatically triggered without additional government action.
What is the function of the automatic stabilizer? ›
Automatic stabilizers are mechanisms built into government budgets, without any vote from legislators, that increase spending or decrease taxes when the economy slows.
What is the purpose of the automatic stabilizers quizlet? ›
Because they affect disposable personal income directly, automatic stabilizers act swiftly to reduce the degree of changes in real GDP.
What are the disadvantages of automatic stabilizers? ›
Automatic stabilizers are essential fiscal policy tools that governments use to stabilize the economy during times of fluctuations. However, they also have some disadvantages, including lack of control, inefficiency, cost, reduced incentives, and limited effectiveness.
What happens as a result of the existence of automatic stabilizers? ›
That is, the automatic stabilizers cause the budget to go into deficit (higher spending and lower tax revenues) during recessions and to go into surplus (lower spending and higher tax revenues) during booms.
What are the two basic categories of automatic stabilizers? ›
The two types of automatic stabilizers are those that are contractionary, implemented during a period of expansion to avoid overheating, and those that are expansionary, implemented during a period of recession to avoid slipping into depression.
How do automatic stabilizers help to reduce the impact of a recession? ›
"Automatic stabilizers" adjust federal spending and taxes during an economic downturn. These budget mechanisms can help keep the economy afloat when unemployment is high and incomes fall.
Answer & Explanation. The answers are; unemployment benefits, food stamps and the tax rate.
What other things the same automatic stabilizers tend to? ›
Other things the same, automatic stabilizers tend to raise expenditures during expansions and recessions.
What do automatic stabilizers lead to? ›
Automatic stabilizers, by design, widen budget deficits during downturns and reduce deficits during upswings. For example, the government brings in less tax revenue during a recession while increasing spending on transfers and other payments.
Are unemployment benefits automatic stabilizers? ›
While UI, like other automatic stabilizers, is designed to automatically spur aggregate demand when private spending falls (in UI's case by temporarily replacing some lost wages of jobless workers), the boost is weaker than it could be.
What other things equal automatic stabilizers tend to? ›
During recessions, the automatic stabilizers tend to increase the budget deficit, so if the economy was instead at full employment, the deficit would be reduced.
Do automatic stabilizers shift AD or SRAS? ›
It is important to note that changes in expenditures and taxes that occur through automatic stabilizers do not shift the aggregate demand curve. Because they are automatic, their operation is already incorporated in the curve itself.
How do taxes stabilize the economy? ›
This is called contractionary fiscal policy. To reduce the total level of spending, the government could increase tax rates. As more income is collected in taxes, less is available for spending, reducing inflationary pressures. Less government spending would work in the same way.
What is the meaning of economic stabilizer? ›
economic stabilizer, any of the institutions and practices in an economy that serve to reduce fluctuations in the business cycle through offsetting effects on the amounts of income available for spending (disposable income).
How do automatic stabilizers affect multipliers? ›
As the impact of a positive multiplier, in reaction to an expansionary fiscal policy, may well become diluted by the operation of automatic stabilisers. The greater the multiplier effect, the greater the restraint automatic stabilisers place on the upturn in the economy.
