Automatic Stabilizer

What is an Automatic Stabilizer?

The term automatic stabilizer refers to a fiscal policy formulation that is designed as an immediate response to fluctuations in the economic activity of a certain country. The normal operation of the tools is such that no additional authorization is required by policymakers or the governments. The measures get automatically triggered when there is instability in the economic cycle.

Automatic stabilizers are created with the goal to stabilize income levels, consumption patterns or demand, business spending, etc. Such policies are more favored by those belonging to the Keynesian School of Economics, as they believe that demand-side measures are necessary for combating an economic slump or a recession.

A common example of automatic stabilizers is corporate and personal income taxes that are progressively graduated, which means that they are fixed in proportion to the income levels of the taxpayer. Other examples include transfer systems, such as unemployment insurance, welfare, stimulus checks, etc.

Automatic Stabilizers and Keynesian Counter-Cyclical Deficit Spending

Keynesian economics prescribes that the government follows counter-cyclical spending. It means that the government must intervene to combat volatility during business cycles by increasing spending during an economic downturn. It is different from a pro-cyclical fiscal policy, which prescribes that a government should follow austerity measures during an economic bust and vice versa.

How Progressive Taxation Stabilizes Economic Cycles

Automatic stabilizers achieve a counter-cyclical fiscal policy by their normal functioning. During a period of drastic growth and high-income levels, i.e., an economic boom, they take out money from the economy. For example, under the progressive taxation regime, as incomes increase, the share of income that must be paid in the form of taxes also increases.

As incomes fall, the tax bracket of the taxpayer changes, which means that the share of income they must pay in the form of taxes also decreases. The tax bracket assigned to an individual is directly tied to their income level.

How Unemployment Insurance Stabilize Economic Cycles

Similarly, when the economy is an expansionary phase, there is a low level of unemployment. It means that fewer people are filing claims for unemployment benefits, and thus, the transfer payments made by the government as part of unemployment insurance also decrease. When an individual becomes unemployed, they need to file a claim and receive their transfer payments.

How Automatic Stabilizers Impact Aggregate Demand

During an economic boom, automatic stabilizers enable the government to cool off expansion and even combat inflation. When incomes fall, the same stabilizers can put money back in the system by tax refunds, welfare checks, and other methods to enable large amounts of government spending. Thus, the stabilizers can cushion the economy from negative economic shocks.

Customer spending helps to add to government revenue, and it can then be used to fund the stabilizers during recessions. It enables consumers to keep up their previous consumption pattern(s), hence preventing the overall economy from falling into a demand crisis.

However, Keynesianism prescribes that the stabilizers must be kept in place even if the government needs to run a fiscal deficit to finance them. It is known as counter-cyclical deficit financing. Keynesians say so because demand is considered the primary driver of economic growth.

A recession can quickly become a depression if an economy also witnesses a demand crisis. Thus, the main motive of automatic stabilizers is to increase demand, or at the very least, to maintain the demand level in the economy.

Economic stabilizers are often used in tandem with other forms of policy measures that require authorization. For example, legislation is required to enact one-time tax cuts, tax refunds, government subsidy payments to households or businesses, bailout packages, etc.

Thus, automatic stabilizers are only considered to be the first line of defense in case of an economic downturn. Special intervention in the form of fiscal and monetary policy programs is almost always required to tackle severe recessions.

Related Readings

CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

• Aggregate Supply and Demand
• Economic Indicators
• New Keynesian Economics
• Monetary Policy
• See all economics resources