Monday, August 24, 2009

Automatic Built In Stabilizers

One way to get around the problems of fiscal policy inflexibility and long lags that impede the use of countercyclical fiscal policies is to build automatic stabilizers into the budget. Automatic stabilizers are provisions in the budget that cause government spending to rise or taxes to fall automatically, without legislative action, when GDP fall. Similarly when GDP rises automatic stabilizers cause spending to fall or taxes to rise without any need for direct legislative action.

A good example of automatic stabilizer is unemployment insurance. In USA when the economy goes into recession and unemployment rises, more people receive unemployment benefits, which are paid automatically without further action by legislative. Thus unemployment insurance component of transfers rise during recessions, making fiscal policy automatically more expansionary.

Quantitatively, the most important automatic stabilizer is the income tax system. When economy goes into recession, people’s income fall, and they pay less income tax. This ‘automatic tax cut’ helps cushion the drop in disposable income and prevents aggregate demand from falling as far as it might otherwise. Likewise when people’s income rise during boom, the government collects more income tax revenue, which helps restrain the increase in aggregate demand? Keynesian argues that this automatic fiscal policy is a major reason for the increased stability of economy since World War II.

A side effect of automatic stabilizer is that government budget tends to increase in recession because government spending automatically rises and taxes automatically fall when GDP declines. Similarly the deficit tends to fall in boom.


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