Revision - Automatic Stabilisers

Are there ways in which an economy can self stabilize in the event of an external shock? The answer is yes if an economic system contains automatic stabilizers. This brief revision note looks at what they are.

Automatic stabilizers refer to how fiscal policy instruments will influence the rate of GDP growth and help counter swings in the business cycle.

During phases of high economic growth, automatic stabilizers will help to reduce the growth rate and avoid the risks of an unsustainable boom and accelerating inflation. With higher growth, the government will receive more tax revenues - since people earn more and so pay extra income tax (note the tax rate doesn’t change, the % just becomes higher). With higher growth, there will also be a fall in unemployment so the government will spend less on unemployment and other welfare benefits.

Conversely in a recession, economic growth becomes negative but automatic stabilizers will help to limit the fall in growth. With lower incomes people pay less tax, and government spending on unemployment benefits will increase. The result is an automatic increase in government borrowing with the state sector injecting extra demand into the circular flow.

How strong are the automatic stabilizer effects? Recent evidence from the OECD suggests that a government allowing the fiscal automatic stabilizers to work might help to reduce the volatility of the economic cycle by up to 20 per cent. The strength of the automatic stabilizers is linked to the size of the government sector (e.g. government spending as a % of GDP), the progressivity of the tax system and how many welfare benefits are income-related.

In short automatic stabilizers help to provide a cushion of demand in an economy and support output during a recession.