Because taxes are based on personal income and corporate profits, a rise in aggregate demand automatically increases tax payments, reducing disposable income and thus spending. On the spending side, stronger aggregate demand typically means lower unemployment, so there is less need for government spending on unemployment benefits, welfare, Medicaid, and other programs in the social safety net. The combination of these automatic stabilizing effects is to prevent aggregate demand from rising as high as it otherwise would, so that inflationary pressure is dampened.Ī glance back at economic history provides a second illustration of the power of automatic stabilizers. Consider the situation where aggregate demand has risen sharply, causing the macro equilibrium to occur at a level of output above potential GDP. All of these things serve to buoy aggregate demand and prevent it from falling as far as it otherwise would. Additionally, since their income has fallen, so have their tax liabilities. As individuals are laid-off, they qualify for unemployment compensation, food stamps and other welfare programs. Consider, though, the effects of automatic stabilizers. The lower level of aggregate demand and higher unemployment will tend to pull down personal incomes and corporate profits, which would tend to reduce consumer and investment spending, further cutting aggregate demand and GDP. Counterbalancing Recession and BoomĪutomatic stabilizers include unemployment insurance, food stamps, and the personal and corporate income tax. Suppose aggregate demand were to fall sharply so that a recession occurred. Instead, they prevent aggregate demand from falling as much as it otherwise would in recession, or they hold down aggregate demand in a potentially inflationary boom. Changes in tax and spending levels can also occur automatically through non-discretionary spending, due to automatic stabilizers, which are programs that are already in place, and thus do not require Congress to act. The stimulus package of 2009 is an example. Discretionary fiscal policy occurs when the Federal government passes a new law to explicitly change tax rates or spending levels.

Automatic stabilizers, like welfare programs such as food stamps, automatically kick in when aggregate demand falls.įiscal policies include discretionary fiscal policy and automatic stabilizers. Describe how fiscal policy can be designed to stabilize the economy using automatic stabilizersįigure 1.

Automatic stabilizers macroeconomics