Automatic Stabilizers

&
Spending Multiplier
Unit 12 - Lesson 3

Learning outcomes:
Explain how factors including progressive tax system and
unemployment benefits, which are influenced by the level
of economic activity automatically help to stabilize shortterm fluctuations.
Explain how Government spending can be further
influenced by the Multiplier.

Automatic Stabilizers
Automatic Stabilizer are Non-Discretionary Policies
Benefit because there is no time lag from Political disagreement on best
way to implement.
Two important Automatic Stabilizers:
1. Progressive Income Taxes
2. Unemployment Benefits

Progressive Income Taxes

Progressive Income Taxes:
If the economy is experiencing an Inflationary Gap

AO > PO
Unemployment < NRU

As Real GDP and Incomes rise so does the tax

revenues of the Government because of the
progressive tax.
Tragakes, pg. 324

Reduces the disposable income of the citizens and

dampens (decreasing) Aggregate Demand

Progressive Tax
Progressive Income Taxes:
If the economy is experiencing a Recessionary Gap

AO < PO
Unemployment > NRU

As Real GDP and Incomes decrease so does the tax

revenues of the Government because of the
progressive tax. People pay less taxes.
Tragakes, pg. 340

The after tax disposable income of the citizens

increases and increases Aggregate Demand

Unemployment Benefits
Unemployment Benefits in a Recessionary Gap

AO < PO
Unemployment > NRU

So, unemployment benefits help:

1.
2.

Allows the unemployed worker to continue to

consume thus supporting AD
Increases Government Spending which
supports AD

With no Unemployment Benefits, the economy

would experience a much greater decrease in AD.

Tragakes, pg. 340

Unemployment Benefits
Unemployment Benefits in an Inflationary Gap

AO > PO
Unemployment < NRU

So, unemployment benefits help:

1.

Less unemployed individuals so Government does

not need to spend as much on Unemployment
Benefits thus decreasing Government Spending
and influencing AD.
Tragakes, pg. 324

With no Unemployment Benefits, the economy would

experience a much greater decrease in AD.

Multiplier - Discretionary Fiscal Policy

Effect of Government Spending is related to the value of the
Multiplier
Increase in Government Spending as a part of Expansionary Fiscal
Policy.
The influence on AD depends on the size of the Multiplier which
depends on the MPC (Marginal Propensity to Consume).
Larger the size of the MPC (meaning a smaller amount of leakages),
the greater impact the Expansionary Fiscal Policy will have on AD.
Effect of a change in tax rate is also related to the value of the
Multiplier

Example
Assume:

Government spends $8 million

Marginal Propensity to Consume is .75
Multiplier = 1 divided by (1 - .75)
Multiplier = 3.33

The effect of Discretionary Fiscal Policy will be $32

million.
The greater the Marginal Propensity to
Consume, the larger the impact of the
Discretionary Fiscal Policy on the Economy.

Tragakes, pg. 342

Fiscal Policy & Long-term Economic Growth

Fiscal Policy focuses mostly on short-term stabilization of an economy.
Does contribute to long term expansion of Potential Output both directly and
indirectly.
Directly
Allocate resources to the
development of physical capital
goods (roads, bridges).
Allocate resources to the
development of human capital
(training, education).
Incentivize firms to invest by
lowering the business taxes.

Indirectly
Creating a stable Macroeconomic
environment allows firms to be
more confident and can lead to
more investment by those firms
thus impacting the Potential Output
of an economy.