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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: