What are automatic stabilizers and how do they affect the economy? Which is the

Question

Explanation / Answer

Automatic stabilizer. We know when there is an autonomous increase in government expenditure or investment or consumption ( exogenous part) then output rises by multiplier times. In a closed economy, We know C= C + cY c= Marginal propensity to consume. Y= C+ I + G So Y= C+ cY + I + G ==? Y= (C+ I+ G)/(1-c) so 1/(1-c) is the multiplier. Now if we involve government taxes (say proportional) we have, C= C+ c(Y-tY) where = proportional tax rate Y= C+ I + G- T ==> Y = C + c(Y-tY) + I + G - T Y - c(Y-tY) = C+ I+G -T Y = (C+I+G-T)/[1-c(1-t)] Here the multiplier is 1/[1-c(1-t)] which is less than 1/(1-c) So we see that now if there increase in G( case with proportional tax) income will rise by 1/[1-c(1-t)] and not by 1/(1-c). So the rise in income will be less. Hence taxes are the automatic stabiliser. This is so because in case of boom, the rise in income will be less and in case of recession the fall in income will be less severe. Similarly unemployment benefits or other transfers by the government are counted as automatic stabiliser as they stabilise the change in output during a recession or the boom. This is so because they reduce the multiplier.

Related Questions

Navigate

• Browse (All)
• Browse W
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.