Question

In higher income countries automatic stabilisers - taxes and government expenditure assist in decreasing the size of the fluctuations in GDP. Explain

Answer 1

Automatic stabilizers are the variables which reduce the ups and downs of a business cycle without any government interventions. The two main automatic stabilizers are income tax and transfer payments. During times of recession the aggregate demand, aggregate output and aggregate employment declines. This reduces the income of the people. When the income level is low the people have to pay less tax. Thus more income is available for the people for consumption. Similarly the unemployed people get income in the form of unemployment allowances and other social security measures. This induces them to consume more. This increase in consumption inturn raises the aggregate demand, aggregate output and employment. Thus the economy moves from recession to recovery. Here the economy is automatically regulated without any government intervention. During times of boom or recovery the automatic stabilizers work in opposite direction. During the time of business expansion aggregate demand, output and employment will be high. At higher level of income, the people have to pay more taxes. This reduces the income available for consumption and the governments transfer payments in the form of unemployment allowances and other social security measures declines. This overall decline in aggregate demand reduces the output, income, and employment and the economy turn to recession. Thus the automatic stabilizers automatically correct the economy to fall in wild depression and wild boom.Unless these automatic stabilizers operate, a mild inflation may turn into a wild boom and a mild deflation may turn into wild depression.

During recession the federal tax revenue declines with the decline in output and income. The federal outlay on unemployment insurance benefit increased. Such reduction in tax revenue and increase in transfer payments temporarily increased the federal budget deficit.

The automatic stabilizers are more important in high income countries. A study on U S economy in the years 2000 shows that the effect of reduced income and payroll tax collection offset 8% decline in GDP through the transfer payments of unemployment allowances.

The experience of U S economy shows that through increased transfer payments and reduced taxes, automatic stabilizers provides significant economic stimulus during and after the Great Recession of 2007-09. The stimulus by automatic stabilizers amounted more than $300 billion annually and the increase in GDP was equal or exceeding %2% of the potential GDP.

The automatic stabilizers are more important in developed countries than in developing countries. The developed countries have attained substantial growth rate as such their main concern to stabilize the economy from wide fluctuations. The automatic stabilizers are powerful in these countries as they operate without any government intervention and prevent the economy from falling in to wide fluctuations.

As far as the developing countries concerns they have little importance on stabilizing the economy but to achieve high economic growth. Thus they have less importance over the automatic stabilizers. But steady rise in price level is essential for attaining the objective of full employment in these countries. The automatic stabilizers help them in stabilizing the price level for a steady growth.