Monetary and Fiscal Policy Fiscal Policy: The Mainstream Automatic Stabilizers Page 1 of 2 Sometimes a small change in the economy can have a big effect on real gross domestic product. If consumers decide they want to spend more money, they create income for other consumers who want to spend more, and through the multiplier process a small change in autonomist spending results in a big change in output. Well, this is one of the things that causes the business cycle to be as severe as it can be. The multiplier effect and the fact that once income starts moving in one direction, everybody tends to ride it along increasing their spending as well until something else changes, we peak out and tank in the other direction. The economy can move in jerky fashions like a roller coaster and everybody’s got a stake in things being more stable. We would all for output and employment and all of these other variables to be more reliable, more stable. Therefore, what we look for is policy measures that can increase stability. One of the things that can increase stability is activist fiscal policy. That is, if it’s executed well, an increase in government spending can compensate for a reduction in consumer spending keeping the economy at full employment. Or if consumers decide they don’t want to spend money, the government can coax them to spend more by giving them a tax cut. However, there is a form of government policy that works passively without an active government decision and these are the automatic stabilizers that are built into the government budget. Whenever output begins to increase, there are certain characteristics of the government budget that slow down the multiplier process and cause consumption spending to increase at a slower rate than income, and this ends up dampening the business cycle and causing the roller coaster to be a little less extreme. Let’s think about what those automatic stabilizers are and then show how they would be represented in our model. The first automatic stabilizer is the progressive tax system. When income begins to increase in the model, people find themselves in higher tax brackets. If you make more money, you've got to pay a bigger percentage of your income to the government. That means as your income grows, your consumption is going to have to grow at a slower rate and this tends to slow down the boom, and it also tends to keep the recession from being as severe. When your income is decreasing during a period of recession, you're slipping into a lower tax bracket so your consumption doesn’t decrease as fast. Another automatic stabilizer is unemployment insurance and other transfer payments. To qualify for unemployment insurance you have to be unemployed, which is a big decrease in your income. So what the government does during a period of unemployment when people’s incomes have fallen rapidly, is that it pays people unemployment insurance so that they can keep their consumption relatively stable. That is, your consumption falls a lot less than your income decreases during a period of unemployment and this tends to slow down the business cycle. I mean, imagine, without unemployment insurance when you lost your job, your consumption would be radically cut, which would then reduce the grocer’s income and all these effects would be magnified through the economy. But when you lose your job and your income falls, you start collecting money from the government, which allows you to keep your consumption relatively constant and reduces the multiplier effect. On the other hand, when the economy heads into a boom, you stop collecting unemployment and that causes your consumption to increase less rapidly than your income because you're losing a source of money that you had before when you were unemployed. So the progressive tax system and unemployment insurance and other government benefits cause the business cycle to vary less severely than it would in the absence of these two counter-cyclical automatic stabilizers. Again, we call them automatic because the government has set them in place, but doesn’t have to vote on them every time it wants to enact a policy. These are automatically part of the government’s budget, automatically part of the way the government interacts with the macroeconomy. Now let’s see how automatic stabilizers would be represented in our diagram. Here we have aggregate demand and aggregate supply represented in the usual graph. Whenever the economy is booming, it’s because aggregate demand is increased. Suppose aggregate demand has increased due to an increase in consumer confidence. Everybody opens their wallets, they spend more money, and as a result people who work in retail have fatter paychecks so they in turn spend, and the multiplier effect creates a big increase in output and equilibrium from Y0 to Monetary and Fiscal Policy Fiscal Policy: The Mainstream Automatic Stabilizers Page 2 of 2 YB. This is the output level during a boom. So how we would show that is we would move from the regular income level that we start with up to a higher income level during a boom. Then suppose something happens and businesses become fearful and they stop investing because they’re afraid of a new government regulation that’s going to limit their ability to make profits. As a result they stop buying computers and stop building factories and aggregate demand shifts down to this lower level, ADR, standing for recession which means that output is going to shrink to a level lower than the original level and here we got a business cycle. Then maybe it turns around again due to an increase in foreigners’ demand for our exports and the business cycle just goes on and on describing this purple snaky line where output which is measured on the vertical axis increases and decreases over time. Now what’s going to happen if we have automatic stabilizers? With automatic stabilizers, whenever the consumers open their wallets and start spending more money, then the people who run retail stores experience an increase in their income, but now they’re going to have to pay higher taxes because they’re in a higher tax bracket. Because they’re in a higher tax bracket, they are not going to be able to keep as large a percentage of their disposable income as before and therefore their consumption spending grows less rapidly than does their income. The same thing happens as incomes increase. People who were previously collecting unemployment insurance and other government transfer payments, they lose that transfer of payment and therefore their incomes, their spendable income grows less rapidly than the increase in gross domestic product. So people are spending a lot more money, but aggregate demand doesn’t increase as fast whenever we have the automatic stabilizers of progressive taxes and unemployment insurance and other public assistance payments. So the actual increase in income is not as much as the boom income before, in fact, it’s going to be less. The same increase in consumer spending gives us an income of YB prime which is actually less. So if we show the boom income now in blue, that’s going to be a smaller amount than before. So what we get is a business cycle that has lower highs and also turns out higher lows. Let’s see how that works. If we have a situation where businesses become spooked and stop spending money on capital goods, then the people who make those capital goods suffer a decrease in their income. However, they also have to pay less in taxes and they’re able to collect unemployment insurance from the government. So their spending doesn’t increase by as much as the income does. Therefore, aggregate demand in the recession doesn’t fall by as much as it would fall in the absence of automatic stabilizers. So because the automatic stabilizers are present, the economy has a little break on it, it has a cushion, and people’s spending doesn’t fall as fast as it would fall if taxes weren’t progressive and unemployment insurance weren’t available. So what happens then is the business cycle has lower highs and higher lows. And that’s what happens. You end up with the business cycle being dampened by the automatic stabilizers. When the economy booms during a period of increased spending, consumption expenditures increase more slowly than GDP and that puts a break on the rate at which the economy grows. When the economy slips into recession, people can collect transfer payments. Also, people end up paying less in taxes so consumption spending doesn’t fall as rapidly as income does. All in all automatic stabilizers cause the business cycle to be dampened, that is the highs are lower and the lows are higher and there’s not as much instability as there would be in the absence of these stabilizers. .