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REAL ECONOMY: The physical side of the economy dealing with goods, services and resources. This side is concerned with using resources to produce the goods and services that make the satisfaction of wants and needs possible. This should be contrasted with the paper economy, or financial side of the economy.

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AUTOMATIC STABILIZERS:

Taxes and transfer payments that depend on the level of aggregate production and income such that they automatically dampen business-cycle instability without the need for discretionary policy action. Automatic stabilizers are a form of nondiscretionary fiscal policy that do not require explicit action by the government sector to address the ups and downs of the business cycle and the problems of unemployment and inflation.
Automatic stabilizers are a part of the structure of the economy that work to limit the expansions and contractions of the business cycle over what they would be otherwise. Induced taxes and transfer payments, payments from and to the household sector to the government sector, that are based on the level of aggregate production and income are the source of automatic business-cycle stabilization.
  • 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.
The critical feature of automatic stabilizers is that they do in fact work AUTOMATICALLY. There is no need for Congress or the President to enact legislation, pass bills, or to undertake any other policy action. These stabilizers are built into the structure of the economy. The government sets up the rules and criteria under which taxes and transfer payments work. If people meet the criteria, then they pay the taxes or receive the transfer payments. The key is that the total of each depends on people meeting the criteria, and the number qualifying depends on business-cycle activity.

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

Income taxes, especially federal income taxes, largely depend on the level of aggregate production and income in the economy. If production and income rise, then tax collections also rise. Income taxes also tend to be progressive -- the proportion of taxes paid increases with income.
  • 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

Transfer payments, including Social Security to the elderly, unemployment compensation to the unemployed, and welfare to the poor, also depend on the level of aggregate production and income. These, however, work opposite to taxes. If aggregate income rises, transfer payments tend to fall as people are less likely to retire, be unemployed, or fall into the ranks of the poor.
  • 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

The automatic stabilizing actions of taxes and transfer payments provide an alternative to discretionary changes in government spending and taxes that comprise fiscal policy. And more than a few folks -- economists and policy makers -- prefer automatic stabilizers over discretionary fiscal policy. They are preferred because:
  • 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.

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Recommended Citation:

AUTOMATIC STABILIZERS, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2017. [Accessed: April 26, 2017].


Check Out These Related Terms...

     | fiscal policy | expansionary fiscal policy | contractionary fiscal policy | monetary policy | expansionary monetary policy | contractionary monetary policy | Keynesian model | recessionary gap, Keynesian model | inflationary gap, Keynesian model | policy lags |


Or For A Little Background...

     | taxes | transfer payments | full employment | business cycles | inflation | unemployment | induced expenditures | contraction | expansion | disposable income |


And For Further Study...

     | Keynesian equilibrium | two-sector Keynesian model | three-sector Keynesian model | four-sector Keynesian model | Keynesian disequilibrium | recessionary gap | inflationary gap | injections-leakages model | multiplier | aggregate market shocks | self-correction, aggregate market | multiplier | accelerator principle | paradox of thrift |


Related Websites (Will Open in New Window)...

     | Social Security Administration |


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