Automatic stabilizers are economic phenomena which moderate the effect of economic expansions and slowdowns. In periods of economic booms, such factors restrict the growth and in periods of slowdown they partially mitigate the drop in aggregate output.
In economics, the most basic measure of an economy’s income level is the gross domestic product (GDP). GDP comprises of private consumption, business investments, government expenditures and net exports (i.e. exports minus imports). The real GDP changes over time due to a range of factors which are hard to predict and prevent. The cycle of economic booms followed by slowdowns is called a business cycle and it involves distinct phases: expansion, peak, recession, trough and recovery. In economic booms, at least one of the components of productions increase and in periods of economic recession, at least one decreases. Automatic stabilizers are such factors which either reduce the net increase or decrease in a single GDP component or offset a change in one component with an opposite change in another component.
As the name suggests, an automatic stabilizer comes into play on its own and no action by any policymakers is needed to activate an automatic stabilizer. This makes it extremely effective in moderating the impact of economic swings because there is no implementation lag.
The most prominent examples of automatic stabilizers are (a) personal and business taxes and (b) social security expenses such as unemployment insurance.
Personal and business taxes are typically progressive in nature i.e. the rate of tax increases as the income level increases. This feature of the tax system comes handy when there is an economic expansion or recession. In an economic expansion, the tax rate increases due to increase in overall income level which in turn reduces the disposable income. A drop in disposable income reduces the multiplying effect of consumption and business spending. The opposite occurs in an economic recession. When the income level drops, tax obligations drop by a greater degree such that the net drop in income is lower.
Transfer payments i.e. social security expenses such as unemployment insurance or any other such benefits which are payable to unemployed people comes into play in economic recessions. When there is an economic slowdown, companies lay off people thereby reducing the overall employment level. High unemployment rate means more and more people are eligible for government’s social security benefits which in turn increases the government expenditure component of the GDP and partially reduces the magnitude of decline in GDP due to slowdown.