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Automatic Stabilizers
Keynesian fiscal policy theory calls for budget deficits to close a recessionary gap and for budget
surpluses to close an inflationary gap. Certain aspects of the federal government’s budget will
tend to automatically increase the budget deficit (or reduce the surplus) during a recessionary
gap and will tend to automatically increase the budget surplus (or reduce the deficit) during an
inflationary gap. These aspects of the budget are called automatic stabilizers. They are automatic
in that they do not require any legislative change in fiscal policy. They are stabilizers in that they
will tend to move equilibrium Real GDP toward Natural Real GDP.
Automatic stabilizers – taxes and transfer payments that automatically tend to move equilibrium
Real GDP toward Natural Real GDP.
The automatic stabilizers are taxes and transfer payments. Certain transfer payments will
automatically increase during a recessionary gap and will automatically decrease during an
inflationary gap. For example, during a recessionary gap, the number of people qualifying for
unemployment compensation will increase. Certain taxes will automatically decrease during a
recessionary gap and will automatically increase during an inflationary gap. For example, during
an inflationary gap, the income tax paid by individuals and corporations will increase.
Example 3: As a result of the Great Recession, the unemployment rate increased from 4.6% in
2007 to 9.3% in 2009. Unemployment compensation benefits paid increased from $35 billion in
2007 to $106 billion in 2009. Corporate income tax receipts decreased from $370 billion in 2007
to $147 billion in 2009.
Potential Problems with Fiscal Policy
According to Keynesian theory, fiscal policy can and should be used to move the economy
toward Natural Real GDP. But there are four potential problems with attempting to use fiscal
policy to stabilize the economy:
1. There may be a political bias toward expansionary fiscal policy at all times. Keynesian
theory calls for expansionary fiscal policy to close recessionary gaps, and contractionary fiscal
policy to close inflationary gaps. But contractionary fiscal policy (raising taxes and/or reducing
government spending) may be unpopular with the voters. Elected officials may prefer
expansionary fiscal policy (lowering taxes and/or increasing government spending) at all
times.
Example 4: Since the U.S. Constitution took effect in 1789, the federal government has had
annual budget surpluses in more years than it has had annual budget deficits. Until Keynesian
theory was introduced, deficit spending was considered politically unacceptable, except for times
of war. However, since Keynesian theory was introduced in 1936, the federal government has
had budget deficits in all but 12 years.
2. Crowding out may occur. Crowding out occurs when increases in government spending
lead to decreases in private spending. The basic economic problem is scarcity. When
government spending increases, the government is using more of the limited resources.
Fewer resources are available for the private sector (consumption and investment). Which
type of private spending will be crowded out may depend on how the increased government
spending is financed;
a. If increased government spending is paid for with increased taxes, this will mainly reduce
consumption. Tax increases reduce disposable income. A decrease in disposable income
will cause a decrease in both consumption and investment, but will primarily reduce
consumption.
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Fiscal Policy 9 - 4