Short on time? This page is the recap. For explanations, the AD–AS graph and worked examples, use the full study guide.
Recap
- Automatic stabilizers are parts of the tax and transfer system that change by themselves when real GDP changes. No new law or announcement is needed.
- Recession: incomes, spending and profits fall, so tax revenue falls; more people qualify for unemployment benefits and income support, so transfers rise. Disposable income and consumption fall by less, so the recession is milder.
- Expansion: tax revenue rises and transfers fall. Disposable income and consumption rise by less, so the economy is less likely to overheat.
- Discretionary fiscal policy (Topic 3.8) needs a new decision and suffers decision and implementation lags. Stabilizers avoid these lags.
- Stabilizers moderate the business cycle. They do not eliminate output gaps or restore full employment on their own.
Key relationships
| Relationship | Formula or direction | Use it to |
|---|---|---|
| Disposable income | income − taxes + transfers | see why it falls by less than income |
| Change in tax revenue (proportional tax) | tax rate × change in income | find the automatic change in revenue |
| Change in consumption | MPC × change in disposable income | find the first-round change in spending |
| Tax revenue over the cycle | same direction as real GDP | explain the tax stabilizer |
| Transfers over the cycle | opposite direction to real GDP | explain the transfer stabilizer |
| AD–AS effect | AD shifts by less, in either direction | show smaller changes in real GDP and the price level |
Assumptions behind the numbers
- Tax rates and benefit rules do not change; only incomes and the number of people who qualify change.
- The calculations look at the first round of spending only.
- A progressive tax would make the effect stronger (background only).
Mistakes to avoid
- Calling a new tax cut or a new spending plan an automatic stabilizer. If someone decided it, it is discretionary.
- Saying the government “cut taxes” when revenue falls with unchanged rates.
- Reversing transfers: they rise in recessions and fall in expansions.
- Saying stabilizers shift AD right in a recession. AD still shifts left, by less.
- Claiming stabilizers restore full employment. The gap only shrinks.
- Forgetting the expansion side. Stabilizers also restrain booms.
- Treating transfers as government purchases. They act through disposable income.
Quick self-check
VD is the valda, the currency of Valdoria, the fictional country used on these pages.
- Income falls by VD 20 billion and the income tax takes 30% of each valda of income. By how much does tax revenue change? (It falls by VD 6 billion.)
- In the same recession, transfers rise by VD 2 billion. By how much does disposable income fall? (VD 12 billion: 20 − 6 − 2.)
- The MPC is 0.75. By how much does consumption fall in the first round? (VD 9 billion.)
- Is a vote to extend unemployment benefits for an extra six months an automatic stabilizer? (No. It is a new decision, so it is discretionary.)
Next: practice questions.