Automatic stabilizer

In macroeconomics automatic stabilizers work as a tool to dampen fluctuations in real GDP without any explicit policy action by the government. It is a government program that changes automatically depending on GDP and a person’s income,^[1] and acts as a negative feedback loop on GDP.

The size of the government deficit tends to increase as a country enters recession, which may keep national income higher through the multiplier effect.

Furthermore, imports often tend to decrease in a recession, meaning more of the national income is spent at home rather than abroad. This also helps stabilize the economy.

Induced taxes

Government tax revenue tends to fall as a proportion of national income during recessions.

This occurs because of the way tax systems are generally constructed.

• Income tax is generally at least somewhat progressive. If an individual's income rises, then their average tax rate increases. This means that as incomes fall, households pay less as a proportion of their income in direct taxation.
• Corporation tax is generally based on profits, rather than turnover. In a recession profits tend to fall much faster than turnover. Therefore, a corporation pays much less tax while having only slightly less economic activity.

If national income rises, by contrast, then both households and corporations end up paying higher proportions of their income in tax.

This means that in an economic boom tax revenue is higher and in a recession tax revenue is lower; not only in absolute terms but as a proportion of national income.

Other forms of tax do not exhibit these effects, because they are roughly proportionate to income (e.g. taxes on consumption like sales tax or value added tax, or they bear no relation to income (e.g. poll tax or property tax).

Transfer payments

Most governments also pay unemployment and welfare benefits. Generally speaking, the number of unemployed people and those on low incomes who are entitled to other benefits increases in a recession and decreases in a boom.

This means that government expenditure increases automatically in recessions and decreases automatically in a boom in absolute terms. Since the trend of output is to increase in booms and decrease in recessions, expenditure is expected to increase as a share of income in recessions and decrease as a share of income in booms.

When stabilizers don't work

There is broad consensus among economists that the automatic stabilizers often exist and function in the short term.

However, the automatic stabilizers model does not incorporate rational expectations or other microfoundations. No part of economics is in the final analysis a mechanistic process and the existence of the stabilizers can easily be overshadowed by other changes to policy, expectations or markets.

Automatic stabilizers incorporated into the expenditure multiplier

This section incorporates automatic stabilization into a broadly Keynesian multiplier model.

$Multiplier=\frac{1}{1-[MPC(1-T)-MPI]}$

• MPC = Marginal propensity to consume
• T = Induced taxes
• MPI = Marginal Propensity to Import

Holding all other things constant, ceteris paribus, the greater the level of taxes, or the greater the MPI then the value of this multiplier will drop. For example, lets assume that:

→ MPC = 0.8

→ T = 0

→ MPI = 0.2

Here we have an economy with zero marginal taxes and zero transfer payments. If these figures were substituted into the multiplier formula, the resulting figure would be 2.5. This figure would give us the instance where a (for instance) $1 billion change in expenditure would lead to a $2.5 billion change in equilibrium real GDP.

Lets now take an economy where there are positive taxes (an increase from 0 to 0.2), while the MPC and MPI remain the same:

→ MPC = 0.8

→ T = 0.2

→ MPI = 0.2

If these figures were now substituted into the multiplier formula, the resulting figure would be 1.79. This figure would give us the instance where, again, a $1 billion change in expenditure would now lead to only a $1.79 billion change in equilibrium real GDP.

This example shows us how the multiplier is lessened by the existence of an automatic stabiliser, and thus helping to lessen the fluctuations in real GDP as a result from changes in expenditure. Not only does this example work with changes in T, it would also work by changing the MPI while holding MPC and T constant as well.

See also

• Negative feedback

References

1. ^ Sullivan, arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 399. ISBN 0-13-063085-3. http://www.pearsonschool.com/index.cfm?locator=PSZ3R9&PMDbSiteId=2781&PMDbSolutionId=6724&PMDbCategoryId=&PMDbProgramId=12881&level=4.