role of automatic stabilisers

Economic Growth and Sustainability – Role of Automatic Stabilisers

1. Syllabus Mapping (Cambridge International AS & A‑Level Economics 9708)

2. What Are Automatic Stabilisers?

• Built‑in features of the fiscal system that react automatically to changes in national income without any new legislative action.
• Key components (all are part of the tax‑benefit system):
  • Progressive income tax – tax liability rises with income.
  • National Insurance / Social Security contributions – rise when earnings rise.
  • Means‑tested benefits (unemployment benefit, job‑seeker allowance, child benefit, health subsidies, etc.) – increase when earnings fall or when people become unemployed.

3. How Automatic Stabilisers Operate

3.1 During a Recession (Real GDP falls)

1. Household incomes fall → many workers move into lower tax brackets → tax receipts fall.
2. Unemployment rises → more people become eligible for unemployment benefit and other means‑tested payments → government outlays rise.
3. The combined effect raises disposable income relative to a scenario with no stabilisers, cushioning the fall in consumption and limiting the left‑ward shift of AD.

3.2 During an Expansion (Real GDP rises)

1. Household incomes rise → workers move into higher tax brackets → tax receipts increase.
2. Unemployment falls → fewer people qualify for benefits → government outlays fall.
3. The net withdrawal of disposable income damps the right‑ward shift of AD.

3.3 Short‑run vs Long‑run Perspective

• Short‑run: The stabiliser effect is immediate because taxes are collected each pay‑period and most benefits are paid monthly.
• Long‑run: Automatic stabilisers do **not** shift the long‑run aggregate supply (LRAS) curve; they merely smooth the business‑cycle fluctuations of AD around the economy’s potential output.
• This distinction reinforces the syllabus idea of *equilibrium* (when AD = LRAS) versus *disequilibrium* (when AD deviates from LRAS).

4. Deriving the Effective MPC and the Multiplier with Automatic Stabilisers

4.1 Starting point – simple Keynesian consumption function

\(C = C_{0} + MPC \times Y_{d}\) where \(Y_{d}=Y - T\) (disposable income).

4.2 Incorporating taxes (average tax rate \(t\))

\(T = tY\) → \(Y_{d}=Y - tY = Y(1-t)\)

4.3 Adding benefits (benefit rate \(b\))

Government transfers are a proportion of income: \(B = bY\). Since transfers are received, they are added to consumption: \(C = C_{0} + MPC \times Y(1-t) + bY\)

4.4 Rearranging to show the effective marginal propensity to consume

\(C = C_{0} + \big[ MPC(1-t) + b \big]Y\) Define the **effective MPC** as \(MPC_{eff}= MPC(1-t) + b\) (the “+ b” term reflects the extra consumption financed by benefits). If benefits are *means‑tested* and fall when income rises, the term becomes **\(-b\)**. For the standard Cambridge formulation (benefits fall when income rises) we write: \(MPC_{eff}= MPC(1-t) - b\)

4.5 Multiplier with automatic stabilisers

The fiscal multiplier is \(k = \dfrac{1}{1 - MPC_{eff}}\). Substituting the expression for \(MPC_{eff}\): \[ k_{AS}= \frac{1}{1-\big[ MPC(1-t)-b \big]} \]

4.6 Step‑by‑step box (for exam practice)

5. Numerical Illustrations

These three scenarios show how increasing the tax rate or the benefit rate reduces the effective MPC and therefore the size of the multiplier, limiting the amplitude of AD fluctuations.

6. AD‑AS Diagram – Visualising the Stabiliser Effect

What the student should draw:

• Vertical LRAS (potential output).
• SRAS upward‑sloping.
• Three AD curves:
  • AD₁ – initial aggregate demand.
  • AD₂ – left‑ward shift caused by a recessionary shock (no stabilisers).
  • AD₂′ – the same shock **with** automatic stabilisers; the curve is less far left.
• Mark equilibrium points:
  • E₁ (AD₁ ∩ SRAS) – output \(Y_{1}\), price level \(P_{1}\).
  • E₂ (AD₂ ∩ SRAS) – output \(Y_{2}\) (deep fall).
  • E₂′ (AD₂′ ∩ SRAS) – output \(Y_{2′}\) (closer to \(Y_{1}\)).
• Label the horizontal distance between AD₂ and AD₂′ as the “stabiliser effect”.

7. Contribution to the Four Macro‑Policy Objectives

• Price‑stability objective: By dampening large swings in AD, stabilisers reduce the risk of demand‑pull inflation in booms and deflation in deep recessions.
• Low‑unemployment objective: Benefit payments keep disposable income flowing, sustaining consumption and preventing a sharp fall in demand that would otherwise magnify job losses.
• Sustainable‑growth objective: Smoother AD paths protect the capital stock (less “stop‑and‑go” investment) and preserve human capital by maintaining household income over the business cycle.
• Equity objective: Progressive taxation and means‑tested benefits automatically redistribute income, narrowing the inequality gap without the need for discretionary policy.

8. Limitations & Criticisms

• Insufficient magnitude: In severe external shocks (e.g., global financial crisis) the automatic response may be too small to avert a deep recession.
• Design can be regressive: If benefit eligibility thresholds are set too high, low‑income households receive little support, weakening the stabiliser effect.
• Revenue volatility: Heavy reliance on tax‑based stabilisers can reduce fiscal space during booms, limiting the government’s ability to fund long‑term investment projects.
• Administrative lags: Although “automatic”, some benefits (e.g., unemployment insurance) require processing time, delaying the stabilising impact.

9. Summary – Key Take‑aways

1. Automatic stabilisers are built‑in fiscal mechanisms (progressive taxes and means‑tested benefits) that react automatically to changes in national income.
2. They lower the effective marginal propensity to consume, reducing the fiscal multiplier and smoothing fluctuations in aggregate demand.
3. Through the AD‑AS framework they keep output nearer to potential, supporting price stability, low unemployment, sustainable growth and equity.
4. They complement discretionary fiscal policy but cannot replace active measures when faced with very large shocks.