Automatic Stabilizers

The result is higher government spending and lower tax collections and the increased likelihood that the government will run a budget deficit. Similarly, when the economy grows rapidly, tax collections increase and government expenditures on transfer payments decrease, and the likelihood of the federal government running a surplus is greater. Now suppose an economy had a balanced federal budget neither deficit nor surplus. An external shock (such as a dramatic increase in oil prices or drought) then plunged the economy into a recession. Tax revenues fall and expenditures on transfer payments increase, resulting in a budget deficit. Believe it or not, the deficit actually serves a valuable role in stabilizing the economy. It works through three channels: †¢Increased transfer payments such as unemployment insurance, food stamps, and other welfare payments increase the income of some households, partly offsetting the fall in household income. †¢Other households whose incomes are falling pay less in taxes, which partly offsets the decline in their household income. Because incomes do not fall as much as they would have in the absence of the deficit, consumption spending does not decline as much. †¢Because the corporation tax depends upon corporate profits and profits fall in a recession, taxes on businesses also fall. Lower corporate taxes prevent businesses from cutting spending as much as they would otherwise during a recession. The government deficit itself, in effect, offsets part of the adverse effect of the recession and thus helps stabilize the economy. Similarly, during an economic boom, transfer payments fall and tax revenues increase. This dampens the increase in household income and also the increase in consumption and investment spending that would accompany higher household income and higher corporate profits. Stabilization policy is an action taken to move the economy closer to full employment or potential output. Transfer payments that stabilize GDP without requiring explicit actions by policymakers are called automatic stabilizers. The great virtue of automatic stabilizers is that they do not require explicit action from the president and Congress to change the law. Given the long inside lags caused by ideological battles in Washington, D. C. , over spending, taxes, and the deficit, it is fortunate that we have mechanisms in place to dampen economic fluctuations without requiring explicit and deliberative action. Reference link: http://classof1. com/homework-help/economics-homework-help