AP® Macroeconomics review sheet from Aim for Five (aimforfive.com/macro/units/3/3-9)
Unit 3 · Topic 3.9
3.9 Automatic Stabilizers
Automatic stabilizers are parts of the tax and transfer system that push against the business cycle without any new decision by lawmakers. In a recession they cushion falling spending, and in a boom they slow spending down. They make swings in the economy smaller, though they can't eliminate them.
Key terms
- automatic stabilizers
- nondiscretionary fiscal policy
- progressive income tax
- unemployment insurance
- transfer payments
How they work
Some taxes and government payments are set up so they change automatically when incomes change. Nobody has to notice a recession, pass a law or wait for it to take effect.
In a recession, incomes fall. People pay less income tax because they earn less, and more people qualify for programs like unemployment insurance and food assistance. Both leave households with more disposable income than they would otherwise have, so consumption falls by less and the drop in AD is smaller.
In an expansion, incomes rise. Tax payments rise, and fewer people receive transfer payments. That takes some spending power out of the economy, slowing the growth of consumption and helping keep the economy from overheating.
Main examples
- Progressive income tax: people with higher incomes pay a larger share of their income in tax. As incomes rise in a boom, tax collections rise even faster; as they fall in a recession, collections fall even faster.
- Unemployment insurance: payments to workers who lose their jobs rise automatically as layoffs increase.
- Other social programs whose transfer payments depend on income, such as food assistance, which more families qualify for when incomes fall.
Automatic vs. discretionary
Discretionary fiscal policy (3.8) needs a new decision: Congress votes to cut taxes or build new roads. That brings recognition and decision lags. Automatic stabilizers skip those lags because the rules are already in place. They're sometimes called nondiscretionary fiscal policy.
Automatic stabilizers also affect the government budget. In a recession, tax revenue falls and transfer payments rise, so the budget moves toward a deficit even if lawmakers change nothing. In a boom, it moves toward a surplus. That's worth remembering for 5.4.
They soften the business cycle but don't erase it. A deep recession can still require discretionary fiscal policy or monetary policy if policymakers decide to act.
On the AD–AS graph, you can picture it this way: when a recession hits, AD still shifts left, but not as far as it would without stabilizers, because disposable income and consumption fall by less. In a boom, AD shifts right by less than it otherwise would. How strong the effect is depends on how progressive the tax system is and how many people the transfer programs reach.
Worked examples
Try each one yourself first, then open the solution.
- Example 1Calculator allowed
How a tax cushions a fall in income
In a recession, households' pre-tax income falls by $1,000 billion. The tax system takes 20% of each dollar of income, and the MPC out of disposable income is 0.8. (a) By how much do tax payments fall? (b) By how much does disposable income fall? (c) How much does the first-round drop in consumption shrink compared with a system with no income tax?
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- Step 1: (a) Tax payments fall by 20% of $1,000 billion = $200 billion. No law changed; it happened automatically.
- Step 2: (b) Disposable income falls by only $1,000 − $200 = $800 billion.
- Step 3: (c) With the tax, consumption falls by 0.8 × $800 billion = $640 billion in the first round. With no income tax, disposable income would fall the full $1,000 billion and consumption by 0.8 × $1,000 billion = $800 billion.
- Step 4: The automatic drop in tax payments softens the first-round fall in consumption by $800 − $640 = $160 billion.
Answer: (a) $200 billion. (b) $800 billion. (c) Consumption falls $640 billion instead of $800 billion, a $160 billion smaller drop.
- Example 2
Automatic or discretionary?
Classify each as an automatic stabilizer or discretionary fiscal policy: (1) unemployment benefit payments rise as layoffs spread; (2) Congress passes a one-time tax rebate; (3) income tax collections fall as wages fall; (4) the government approves a new bridge-building program to create jobs.
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- Step 1: (1) Benefits rise under existing rules without a new law: automatic stabilizer.
- Step 2: (2) A new law was needed: discretionary.
- Step 3: (3) Collections fall because incomes fell, under the existing tax code: automatic stabilizer.
- Step 4: (4) A new spending decision: discretionary.
Answer: (1) Automatic. (2) Discretionary. (3) Automatic. (4) Discretionary.
Common mistakes
- Calling any tax cut an automatic stabilizer. A tax cut that requires a new law is discretionary.
- Getting the direction backward. In a recession, tax revenue falls and transfers rise; in a boom, tax revenue rises and transfers fall.
- Thinking automatic stabilizers end recessions. They reduce how far spending falls; they don't guarantee full employment.
- Forgetting that automatic stabilizers push the budget toward a deficit in recessions without any policy change.
On the exam
- This topic shows up mainly in multiple choice: identify an automatic stabilizer, or predict how tax revenue and transfer payments change over the business cycle.
- If you explain one in writing, describe the chain: income changes, taxes and transfers change automatically, disposable income changes less, so consumption and AD change less.
Connected topics
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Check yourself
4 questions on 3.9 Automatic Stabilizers. Pick an answer to see if you got it, and why.
Which of the following is an example of an automatic stabilizer?
With a progressive income tax, what happens automatically to tax revenues as an economy enters a recession, and how does this affect the economy?
During a rapid economic expansion, how do automatic stabilizers affect the economy?
Which of the following best describes the effect of automatic stabilizers on the business cycle?
0 of 4 answered