Download Automatic Stabilizers and Stabilization Policy

Automatic Stabilizers and Stabilization Policy
Unit V – Fiscal Policy and Stabilization
Mr. Stewart’s AP Macroeconomics
Spring Semester 2014
Automatic Stabilizers
Definition (Investopedia.com):
Economic policies and programs that are designed to offset fluctuations in a
nation's economic activity without intervention by the government or
policymakers. The best-known automatic stabilizers are corporate and
personal taxes, and transfer systems such as unemployment insurance and
welfare. Automatic stabilizers are so called because they act to stabilize
economic cycles and are automatically triggered without explicit government
intervention.
Explanation (AmosWeb.com):
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 businesscycle 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.
Article (CBSNews.com):
The Importance of Automatic Stabilizers to the Economy
Last Updated Jan 25, 2010 12:52 PM EST
Automatic stabilizers are a key factor in easing the consequences of negative
economic shocks. What are automatic stabilizers and how do they work? In an
earlier post on this topic, Social Insurance and the Severity of Recessions, I wrote
that:
The question of how bad would economic conditions be right now if there had been
no stimulus package and no financial bailout is receiving considerable attention.
There's no way to know for sure, but I believe the economy would have been much
worse off without these two policy interventions. ... But one thing I am fairly certain
of, and something I don't think is getting enough attention, is the effect that
automatic stabilizers have had in helping to ease the impact of the recession.
What are automatic stabilizers? Automatic stabilizers are taxes and transfers such
as unemployment compensation and food stamps that automatically change with
changes in economic conditions in a way that dampens economic cycles. For
example, when the economy turns downward, the amount spent on food stamps
automatically goes up as more people apply or eligibility rules are eased. The extra
spending the food stamps generates helps to soften the downturn for the individuals
receiving the help, and also benefits the businesses and employees where the money
is spent (and the multiplier process spreads the benefits more widely). Similarly,
unemployment compensation, which obviously rises as jobs are eliminated, goes up
when conditions deteriorate and this also provides a boost to demand. There are
other factors too...
I don't think there can be any doubt about the importance and effectiveness of social
insurance in helping to limit the impact of economic downturns. ...
Yet, despite their importance in smoothing the impact of economic shocks, very little
discussion of the recent crisis has been devoted to whether the automatic stabilizers
we have in place have been adequate. Why have these stabilizers received so little
attention? One reason is that they are automatic and hence largely outside the
political process, this is one of their advantages, and it's only when programs such
as unemployment compensation threaten to come to an end that they catch our
attention.
As just noted, in addition to their effectiveness at reducing the severity of economic
shocks, automatic stabilizers have an additional advantage of being outside the
political process. One of the difficulties in using fiscal policy to combat recessions is
getting Congress to agree on what measures to implement. Agreeing on tax cuts
versus spending, who should get the tax cuts, how money should be spent, etc., is
difficult if not impossible, and the delays and compromises involved in passing
legislation undermine the effectiveness of the policy. Automatic stabilizers bypass
this difficulty by doing exactly what their name implies, they kick in automatically
without the need for Congressional action.
However, while automatic stabilization policies bypass the political process once
they are operative, the political challenges of putting automatic stabilizers in place
to begin with are just as great, perhaps even greater in some ways, as they are for
implementing fiscal policy on the fly once a recession hits. But the difference is that
negotiations over automatic stabilizers can be carried out when the economy is
doing well and delay isn't as costly, and the negotiations only have to be carried out
once instead of in each and every downturn.
Of course, the motivation for implementing new and improved stabilization policy
will be lower during good economic times, we tend to forget and move on to other
things. That's why it's important to begin the assessment of the automatic
stabilizers we presently have in place right now, while the need for them is still
fresh in our minds.
We need to do a careful and thorough assessment of the strengths and weaknesses
of existing automatic stabilizers, to identify missing pieces and extraneous parts,
and we need to design new stabilizers that can improve our ability to smooth
fluctuations in the economy (e.g. payroll taxes that decline automatically when
conditions deteriorate, investment tax credits that vary counter-cyclically, or a
continuously updated list of infrastructure projects that can be started ahead of
schedule or brought online anew if the economy goes into recession). Then we need
to begin the difficult political process of getting the needed change through
Congress and signed into law before the next crisis hits.
The lags in the effects of policy and the existing political atmosphere mean it's too
late to do much more to help the economy this time around, but we should be as
prepared as we can the next time this happens.
© 2010 CBS Interactive Inc.. All Rights Reserved.
Do you agree with the article’s view on the importance of automatic stabilizers during
the recession? Use claim, evidence, analysis to verify your opinion.
Your Analysis:
Stabilization Policy
Definition (Investopedia.com):
A macroeconomic strategy enacted by governments and central banks
to keep economic growth stable, along with price levels and
unemployment. Ongoing stabilization policy includes monitoring the
business cycle and adjusting benchmark interest rates to control
aggregate demand in the economy. The goal is to avoid erratic
changes in total output, as measured by Gross Domestic Product
(GDP) and large changes in inflation; stabilization of these factors
generally leads to moderate changes in the employment rate as well.
Explanation (AmosWeb.com):
STABILIZATION POLICIES:
Economic policies undertaken by governments to counteract business-cycle
fluctuations and prevent high rates of unemployment and inflation. The two most
common stabilization policies are fiscal and monetary. Stabilization policies are also
termed countercyclical policies, meaning that they attempt to "counter" the natural
ups and downs of business "cycles." Expansionary policies are appropriate to reduce
unemployment during a contraction and contractionary policies are aimed at
reducing inflation during an expansion.
Stabilization policies are government actions, especially fiscal policy and monetary
policy, designed to fix the unemployment and inflation problems created by
business-cycle instability. During periods of high or rising unemployment associated
with a business-cycle contraction, the appropriate action is to stimulate the
economy through expansionary policies. During periods of high or rising inflation
associated with a business-cycle expansion, the appropriate action is to dampen the
economy through contractionary policies.
Fiscal and Monetary
The two most frequently used stabilization policies are fiscal policy and monetary
policy.

Fiscal Policy: This policy makes use of government spending and/or taxes,
the two components of the government's "fiscal" budget. When government
increases or decreases spending, especially by changing the quantity of gross
domestic product purchased, then aggregate production, employment, and
national income are also affected. Government can change the amount of
taxes collected from the public, as well, which then affects the amount of
income available to purchase gross domestic product. This also triggers
changes in aggregate production, employment, and national income.

Monetary Policy: This policy involves the total amount of money in
circulation throughout the economy, as well as interest rates in financial
markets. By changing the amount of money in circulation, the public has
more or less of an ability to purchase gross domestic product, which then
triggers changes in overall economic activity. Money supply changes also
invariably cause changes in interest rates, which subsequently affect the
willingness and ability to borrow the funds used for expenditures.
Expansionary and Contractionary
Stabilization policies can be either expansionary or contractionary, depending on
whether the most pressing problem is excessive unemployment or excessive
inflation.

Expansionary Policy: This policy is designed to stimulate the economy and to
reduce unemployment by countering or preventing a business-cycle
contraction. Expansionary fiscal policy is an increase in government
spending and/or a decrease in taxes. Expansionary monetary policy is an
increase in the money supply and/or a decrease in the interest rate.

Contractionary Policy: This policy is designed to dampen the economy and to
reduce inflation by countering or preventing the inflationary excesses of a
business-cycle expansion. Contractionary fiscal policy is a decrease in
government spending and/or an increase in taxes. Contractionary monetary
policy is a decrease in the money supply and/or an increase in the interest
rate.
A Graphical Illustration
This graph illustrates the
goal of stabilization policies.
The red line is the "natural"
business cycle. Rising and
falling around the blue longrun trend line. But it rises
and falls too much, causing
inflation and
unemployment. Policy
makers would rather have a
business cycle more like
that revealed with a click of
the [Stabilization Policies]
button.
Stabilizing the Business Cycle
Stabilization policies can achieve
this result by countering business
cycle ups and downs. When
unemployment rises with a
business-cycle contraction,
expansionary policies are
appropriate. When inflation
worsens with a business-cycle
expansion, contractionary policies
are appropriate. Once again, note
that stabilization policies are a countercyclical. Contractionary policies counter an expansion and
expansionary policies counter a contraction.
Article (NYTimes.com):
Stabilization Won’t Save Us
By NASSIM NICHOLAS TALEB
Published: December 23, 2012
THE fiscal cliff is not really a “cliff”; the entire country won’t fall into the ocean if we hit it. Some
automatic tax cuts will expire; the government will be forced to cut some expenditures. The cliff is really
just a red herring.
Likewise, any last-minute deal to avoid the spending cuts and tax increases scheduled to go into effect on
Jan. 1 isn’t likely to save us from economic turmoil. It would merely let us continue the policy mistakes
we’ve been making for years, allowing us only to temporarily stabilize the economy rather than address its
deep, systemic failures.
Stabilization, of course, has long been the economic playbook of the United States government; it has kept
interest rates low, shored up banks, purchased bad debts and printed money. But the effect is akin to
treating metastatic cancer with painkillers. It has not only let deeper problems fester, but also aggravated
inequality. Bankers have continued to get rich using taxpayer dollars as both fuel and backstop. And
printing money tends to disproportionately benefit a certain class. The rise in asset prices made the
superrich even richer, while the median family income has dropped.
Overstabilization also corrects problems that ought not to be corrected and renders the economy more
fragile; and in a fragile economy, even small errors can lead to crises and plunge the entire system into
chaos. That’s what happened in 2008. More than four years after that financial crisis began, nothing has
been done to address its root causes.
Our goal instead should be an antifragile system — one in which mistakes don’t ricochet throughout the
economy, but can instead be used to fuel growth. The key elements to such a system are decentralization of
decision making and ensuring that all economic and political actors have some “skin in the game.”
Two of the biggest policy mistakes of the past decade resulted from centralized decision making. First, the
Iraq war, in addition to its tragic outcomes, cost between 40 and 100 times the original estimates. The
second was the 2008 crisis, which I believe resulted from an all-too-powerful Federal Reserve providing
cheap money to stifle economic volatility; this, in turn, led to the accumulation of hidden risks in the
economic system, which cascaded into a major blowup.
Just as we didn’t forecast these two mistakes and their impact, we’ll miss the next ones unless we confront
our error-prone system. Fortunately, the solution can be bipartisan, pleasing both those who decry a large
federal government and those who distrust the market.
First, in a decentralized system, errors are by nature smaller. Switzerland is one of the world’s wealthiest
and most stable countries. It is also highly decentralized — with 26 cantons that are self-governing and
make most of their own budgetary decisions. The absence of a central monopoly on taxation makes them
compete for tax and bureaucratic efficiency. And if the Jura canton goes bankrupt, it will not destabilize the
entire Swiss economy.
In decentralized systems, problems can be solved early and when they are small; stakeholders are also
generally more willing to pay to solve local challenges (like fixing a bridge), which often affect them in a
direct way. And when there are terrible failures in economic management — a bankrupt county, a state illprepared for its pension obligations — these do not necessarily bring the national economy to its knees. In
fact, states and municipalities will learn from the mistakes of others, ultimately making the economy
stronger.
It’s a myth that centralization and size bring “efficiency.” Centralized states are deficit-prone precisely
because they tend to be gamed by lobbyists and large corporations, which increase their size in order to get
the protection of bailouts. No large company should ever be bailed out; it creates a moral hazard.
Consider the difference between Silicon Valley entrepreneurs, who are taught to “fail early and often,” and
large corporations that leech off governments and demand bailouts when they’re in trouble on the pretext
that they are too big to fail. Entrepreneurs don’t ask for bailouts, and their failures do not destabilize the
economy as a whole.
Second, there must be skin in the game across the board, so that nobody can inflict harm on others without
first harming himself. Bankers got rich — and are still rich — from transferring risk to taxpayers (and we
still haven’t seen clawbacks of executive pay at companies that were bailed out). Likewise, Washington
bureaucrats haven’t been exposed to punishment for their errors, whereas officials at the municipal level
often have to face the wrath of voters (and neighbors) who are affected by their mistakes.
If we want our economy not to be merely resilient, but to flourish, we must strive for antifragility. It is the
difference between something that breaks severely after a policy error, and something that thrives from
such mistakes. Since we cannot stop making mistakes and prediction errors, let us make sure their impact is
limited and localized, and can in the long term help ensure our prosperity and growth.
Do you agree with the author’s viewpoint? Why or why not. Use claim, evidence, and
analysis to support your answer.
Your Analysis: