Automatic Stabilizers

Economics: IB Diploma, topic 2.5.4

Automatic stabilizers support the economy during recessions and help prevent the economy from being overheated during expansionary periods.

Automatic stabilizers are said to be 'automatic' in the sense that they are applied through existing mechanisms in the federal government's tax and spending programs.
They are 'stabilizers' in the sense that they aim to counterbalance and smooth the impacts of the business cycle of recession and boom.

When the equilibrium level of output is pushed above potential GDP during a boom, the policy prescription is usually contractionary fiscal policy.
To some extent, this happens automatically.
On the tax side, a rise in aggregate demand means that workers and firms throughout the economy earn more. Because taxes are based on personal income and corporate profits, a rise in aggregate demand automatically increases tax payments.
On the spending side, stronger aggregate demand typically means lower unemployment and fewer layoffs, and so there is less need for government spending on welfare.

The lower level of aggregate demand and higher unemployment will tend to pull down personal incomes and corporate profits, an effect that will reduce the amount of taxes owed automatically.
Higher unemployment and a weaker economy should lead to increased government spending on unemployment benefits, welfare, and other similar domestic programs.

The Global Financial Crisis, starting in late 2007, meant less tax-generating economic activity, which triggered the automatic stabilizers that reduce taxes.
Social service programs also acted to boost AD as their transfer payments kept low income and vulnerable households afloat.
Most economists, even those who are concerned about a possible pattern of persistently large budget deficits, are much less concerned or even quite supportive of larger budget deficits in the short run of a few years during and immediately after a severe recession.

Test yourself on Automatic Stabilizers

Which of the following is NOT an example of an automatic stabilizer?
When would automatic stabilizers kick in?
Why might automatic stabilizers have more impact on the economy now than in 1929?