• An increase in aggregate production and income associated with a business-cycle expansion causes an increase in taxes and a decrease in transfer payments, both of which limit the increase in disposable income and thus also limit the expansion.


• Alternatively, a decrease in aggregate production and income associated with a business-cycle contraction causes a decrease in taxes and an increase in transfer payments, both of which limit the decrease in disposable income and thus also limit the contraction.

Automatic stabilizers largely came into existence in response to the Great Depression of the 1930s. In the decades preceeding the Great Depression, business cycles tended to be particularly volatile. In the decades following the Great Depression, business cycles were substantially more subdued. Automatic stabilizers are given at least partial credit for the increased stability of recent times.

Let's take a closer look at each of the two automatic stabilizers -- taxes and transfer payments.

Taxes

• An Expansion: The progressive nature of income taxes automatically act to stabilize a business-cycle expansion, limiting the upswing of a business cycle that might tend to cause inflation. As the economy expands, and aggregate income increases, people pay an increasing proportion of income in taxes. This leaves proportionally less disposable income available for consumption expenditures and further expansionary stimulation. In other words, the expansion is not as robust, not as great as it would be without progressive income taxes.


• A Contraction: The progressive nature of income taxes also automatically stabilize the downswing of a business-cycle contraction. As the economy declines, and aggregate income falls, people pay a decreasing portion of income in taxes. This then leaves proportionally more disposable income available for consumption expenditures that would be without a progressive income tax system.

Transfer Payments

• An Expansion: The connection between transfer payments and aggregate income also automatically acts to stabilize a business-cycle expansion, limiting the upswing of a business cycle that might cause inflation. As the economy expands, and aggregate income increases, people receive increasingly fewer transfer payments. The elderly is less likely to retire, fewer workers are likely to find themselves unemployed, and the poor are likely to be less poor and less in need of assistance. This means that the consuming public has less disposable income for consumption expenditures and further expansionary stimulation than they would have if transfer payments did not decline.


• A Contraction: Transfer payments also automatically act to stabilize the downswing of a business-cycle contraction -- which is actually a primary purpose for the existence of transfer payments. As the economy declines, and aggregate income decreases, people are supported by this safety net and receive increasingly more transfer payments. The elderly is more likely to retire, more workers are likely to find themselves unemployed, and people are more likely enter the ranks of the poor in need of assistance. This means that the consuming public has more disposable income for consumption expenditures and further expansionary stimulation than they would have if transfer payments did not increase.

Discretion Not Needed

• Discretionary fiscal policy requires discretionary action and experience potentially lengthy policy lags that make fiscal policy pro-cyclical rather than counter-cyclical.


• Automatic stabilizers, by way of contrast, work automatically and respond almost immediately to changing economic conditions, with little or no policy lags.