Automatic Stabilizers

Did you know that in the U.S. if you are laid off from your job through no fault of your own, you can receive income while you're looking for a new job? Does that sound like a benefit to workers? Well sure, but I bet you didn't imagine that unemployment insurance is also a benefit to the entire economy! How, you ask? Well, a national economy like the U.S. can employ a number of “hidden” tools that help moderate economic fluctuations and keep GDP and prices more stable. These tools are known as automatic stabilizers. Want to learn more about automatic fiscal policy stabilizers and see more automatic stabilizers examples? Keep reading!

Automatic Stabilizers Automatic Stabilizers

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Table of contents

    Automatic Stabilizers Definition

    A national economy experiences what economists call the Business Cycle. Business cycles are periods of economy-wide expansion and then contraction and then expansion again, and so on. When an economy is expanding, incomes are going up, but at the same time, prices are going up! When an economy is contracting, prices are stable or decreasing, but incomes are also stable or decreasing! Automatic stabilizers help smooth out the fluctuations in GDP in order to avoid going to either extreme.

    An economic downturn can cause a domino effect of negative consequences. When people lose their jobs or take pay cuts, their disposable income decreases, which reduces aggregate consumption, which leads to further economic downturn. Automatic stabilizers are programs the government puts in place to help reduce economic downturns and prevent an economy from spiraling. An analogy of automatic stabilizers would be the hand in figure 1.

    Automatic stabilizers, Falling dominoes symbolizing the domino effect, StudySmarterFig 1. - Falling dominos

    Automatic stabilizers are a type of economic policy designed to mitigate fluctuations in GDP. As the name suggests, they are policies that are already in place so that they get implemented automatically when they are needed, without additional government action. During times of economic decline, automatic stabilizers will help to increase aggregate demand. During times of economic growth, automatic stabilizers will help to suppress aggregate demand.

    Automatic stabilizers are economic policies designed to mitigate fluctuations in GDP without additional government action. They function by increasing aggregate demand during periods of recession and suppressing aggregate demand during periods of growth.

    Specific automatic stabilizers in the U.S. include progressive income tax and corporate tax rates, as well as government transfers for social welfare.

    The Purpose of Automatic Stabilizers

    The purpose of automatic stabilizers is to adjust aggregate demand in the economy by increasing or decreasing income. During recessions, automatic stabilizers increase income to stimulate demand. During periods of economic growth, automatic stabilizers decrease income to suppress aggregate demand and reduce growth. Importantly, automatic stabilizers require no government intervention. They have built-in mechanisms for activating, making them useful as a quick response to economic recessions.

    Automatic Stabilizers During Recession

    The fundamental concept behind automatic stabilizers is to increase aggregate demand when the economy is declining and to suppress aggregate demand when the economy is growing. To better understand how automatic stabilizers work, let’s look at an example of how an automatic stabilizer can increase aggregate demand during a recession, when they are implemented to be expansionary.

    Unemployment insurance is a classic example of an automatic stabilizer; it provides temporary financial assistance to workers who get laid off and need to consume less. During a recession, many people may lose their jobs. As household income falls, consumption falls, aggregate demand falls, and GDP falls. Unemployment insurance seeks to prevent job losses from having this impact on GDP.

    For more details on how a shift in aggregate demand works, check out our explanation on the AD-AS Model.

    Consider someone who was earning $31,200 per year, or $600 per week, and then lost their job due to a recession. Unemployment insurance may provide them with $600 per week for up to six months while they look for a new job. If they find a new job within that six-month period that also pays $31,200, then they were able to consume their usual amount during that period of unemployment and experience no actual loss of income!

    This helps dampen the negative effects of a recession on aggregate demand. Unemployment insurance is also something people can qualify for right away without the need for additional government legislation, making the policy “automatic.”

    Automatic Stabilizers During Economic Growth

    Automatic stabilizers can also work to moderate consumption during times of growth. In this case, they are referred to as contractionary. When the economy is growing rapidly, it may be wise to limit aggregate demand to control inflation. Automatic stabilizers can help with this. Let’s look at an example of how an automatic stabilizer can decrease aggregate demand during an expansion.

    Progressive tax brackets are a type of automatic stabilizer that can help moderate increases in economic growth. They work by increasing the tax rate as income grows.

    A progressive tax is a tax where the tax rate increases as the amount being taxed increases. Under a progressive income tax system, taxpayers who earn more income will pay not only more tax dollars, but a higher percentage of their overall income than those who earn less. This is one of many factors that helps stabilize the national economy.

    Automatic stabilizers, Progressive income taxes, StudySmarterFig 2. - Progressive income taxes

    After the government designs and implements a progressive income tax system and/or corporate income tax system, the tax rates will automatically adjust based on an individual's or corporation's actual income. Figure 2 shows a tax calculator. If an individual receives a pay cut, their tax rate will automatically decrease without any additional action on behalf of the government. This will help to lessen the reduction in aggregate demand.

    Consider a progressive income tax system in which the first $40,000 that someone makes is taxed at 10%. The next $40,000 is taxed at 20%, and the next $40,000 after that is taxed at 30%. If your income is $100,000, how much do you owe in taxes? What percentage of your overall income are you paying in taxes? That is your effective tax rate. How does your effective tax rate at a $100,000 income compare with the effective tax rate of someone who earned a $40,000 income?

    Let’s break it down. Your first $40,000 would be taxed at 10%, which equals $4,000 in taxes. Your next $40,000 would be taxed at 20%, which equals $8,000. The final $20,000 of your income would be taxed at the highest rate of 30%, which equals $6,000. Thus, the total tax bill would be $4,000 + $8,000 + $6,000 which equals $18,000.

    You paid an effective tax rate of 18% because your taxes ($18,000) were 18% of your total income ($100,000). Someone who earned $40,000 pays 10% in taxes. Granted your $100,000 income is 2.5 times higher than the individual who earned $40,000, you would indeed pay a higher tax rate than that individual in a progressive income tax system. This feature helps stabilize the economy.

    Automatic Stabilizers Example

    There are many examples of contractionary and expansionary automatic stabilizers that all help to minimize the fluctuations in GDP. Unemployment insurance is an example of an expansionary automatic stabilizer, while progressive income tax and corporate income tax are examples of contractionary automatic stabilizers.

    Another important type of automatic stabilizer is government social services programs, also called welfare programs, such as food stamps. Any government transfers to people experiencing lower income are acting as automatic stabilizers. Those transfer payments are helping to boost individuals' and families' ability to consume, thus increasing aggregate demand and supporting GDP.

    Automatic Fiscal Policy Stabilizer

    Automatic stabilizers are a crucial part of governments’ fiscal policy. Fiscal policy is how the government spends money and taxes income in order to influence economic conditions. During a recession, the government will need to take steps to mitigate economic harm. While some actions like stimulus packages can help, they also take a long time to design, get voted on, and pass.

    The economy often needs support to stimulate or dampen demand much more quickly. Automatic stabilizers are extremely useful in this regard because they activate without any action required from the government. Once a government has created automatic stabilizers, they work to stabilize fluctuations in GDP on their own.

    It's important to note how these changes are automatic. Consider a progressive tax system. When an economy is starting to overheat and inflation is soaring, the rise in incomes will increase not just tax amounts, but tax rates, and this serves to automatically curb demand. Likewise, when an economy is slipping into recession and unemployment is on the rise, the tax rates will fall due to lower incomes, and this serves to automatically help increase demand, as does unemployment insurance too.

    Fiscal policy is the government's use of spending and taxation to influence the economy. Governments are usually interested in stimulating growth while curbing inflation and unemployment.

    Automatic Stabilizers - Key Takeaways

    • A recession can have a domino effect. As people lose their jobs or take pay cuts, household income decreases, suppressing aggregate demand and consumer spending. As a result, businesses will make less money, leading to more layoffs and pay cuts.

    • Automatic stabilizers are a type of economic policy designed to mitigate fluctuations in GDP. Once established, they take effect without requiring explicit action from the government.

    • Automatic stabilizers function by increasing aggregate demand during times of recession and decreasing aggregate demand during times of growth.

    • Examples of automatic stabilizers include:

      • Unemployment insurance

      • Food stamps and other government transfers

      • Progressive income tax and corporate income tax

    • Automatic stabilizers play an important role in the government’s response to recessions. Measures such as stimulus packages take time to create and implement, but automatic stabilizers can activate instantly and respond immediately to changes in GDP and household income.

    Frequently Asked Questions about Automatic Stabilizers

    What are the types 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.

    What are automatic stabilizers?

    Automatic stabilizers are economic policies designed to mitigate fluctuations in GDP without additional government action.

    How will automatic stabilizers affect the economy during a recession?

    Automatic stabilizers will affect the economy during a recession by reducing the decline in income, thereby reducing the decline in aggregate demand.

    What are examples of automatic stabilizers?

    Some examples of automatic stabilizers are unemployment insurance, food stamps, and the progressive income tax system.

    What are the three automatic stabilizers used in the U.S.?

    The three automatic stabilizers are income tax policy, corporate tax policy, and government transfer rules.

    Test your knowledge with multiple choice flashcards

    Economic downturns can cause a domino effect of negative consequences for the economy.

    During recessions, automatic stabilizers _____ income to _____ demand.

    During periods of economic growth, automatic stabilizers _____ income to _____ aggregate demand.

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