Wednesday, May 25, 2011

Automatic Stabilizer and Discretionary Fiscal and Monetary Policy

In a stable economy relative prices and outputs must be free to vary with changes made in technology, tastes and preferences of consumers and suppliers of factors of production, namely land, labour and capital.

An automatic stabilizer is any feature of the economic system, which automatically tends to reduce the strength of recessions or inflations without any policy changes being made. Automatic adjustments in expenditures or revenues take place to bring about economic stability without deliberate government intervention.

This can be shown in the following diagram.

Taxes act in such a way that the economy is automatically stabilized. At full-employment National Income NP1, tax revenues are just adequate to cover government expenditure (E). Now if business activity falls and the economy swings down into a recession to NP2, tax collections fall as income falls, and the budget automatically moves towards a deficit. CD measures the amount of deficit at NP2. As tax collections fall, more disposable income is left in the hands of the public. Thus the downward trend is checked as demand increases, and the budget deficit is wiped off.

The tax system also acts as a restraint to upward swing. As National Income rises from NP1 to NP3, tax collections rise and this produces a budget surplus. As a result the disposable income in the hands of public is reduced. This reduces the demand and subsequently inflation. Thus the upward momentum is slowed down.

The degree of automatic stabilization depends on the tax rates. Higher the tax rates, higher will be the degree of stabilization.

Automatic stabilizers are there on the government expenditure side also. During recession unemployment, insurance, compensation and welfare expenditures automatically rise. This maintains the sufficient level of disposable income and checks recession and downward swing by increasing the aggregate demand. The opposite thing happens in case of inflation and budget surplus.

Discretionary Fiscal Policy

Automatic stabilizers can never fully stabilize the economy. So government action is necessary to make the economy stable.

The principal weapons of discretionary fiscal policy are

a) Varying public works and other expenditure programmes
b) Varying transfer expenditure programmes (welfare, subsidy, social security etc.)
c) Varying rates of tax cyclically

Discretionary variations in transfer expenditure programmes and tax rates may have greater short-run stabilizing effects.

Monetary Policy and Fiscal Policy

An important function of the modern government is the attempt to prevent chronic unemployment and stagnant growth and to wipe off the effects of demand inflation or deflation.

Monetary Policy: It is the policy of the Central Bank, which aims at changing the quantity of money or credit conditions. There are various ways like open market operations, change in discount rate etc. The main aim is to ensure that the monetary conditions are consistent with the achievement of the goods of high employment and stable prices.

Fiscal Policy: The government has the ability and responsibility to manage the aggregate demand to ensure a continued prosperity or sustained growth without unemployment and inflation. Fiscal policy is the tool by which the government can affect the aggregate demand. Fiscal policy means change in government expenditure or tax rates.

During depression the government initiates work on public investment projects for the unemployed. These investments are primarily aimed to create work for the people. But the effect of public works on the economy is felt after a certain time. There is a time lag between the launching of the project and generation of production and employment.

Therefore during a mild recession economists rely more on monetary policy than on public works programme (fiscal policy). However, fiscal measures are not to be dispensed with. They should be carried on for their own sake and over long periods of time.

Transfer expenditure programmes (welfare, subsidy, social security etc.) may also be undertaken to stabilize the economy. The government can stop giving some veteran's bonus in inflationary times to bring down the disposable income and aggregate demand and disburse them during periods of depression.

Variation of tax rates: If the economists think that the recession will be brief, a temporary tax cut may prevent income and demand from falling, or a tax rise may be used to eliminate extra demand and inflationary gap.

However there is a need for coordination between fiscal policy and monetary policy. It will not be proper on the part of a government to adopt a restrictive monetary policy when the demand is increasing as a result of an expansionary fiscal policy. An optimum mix of the two must be chosen by the government. In short, fiscal policies, along with stabilizing monetary policies, can provide a favourable and stable economic environment, giving the people a maximum opportunity for achievement.

Automatic Stabilizer Versus Discretionary Fiscal and Monetary Policy

While automatic stabilizers reduce the severity of economic fluctuations, they do not eliminate them. The objective of Discretionary Policy is to reduce the fluctuation even more. So a government should stress on two things.

1) The automatic stabilizers are the first line of defense, but are not sufficient to maintain full stability.

2) Reliance on them in preference to discretionary programme raises some philosophical and ethical questions.

In short, a built-in stabilizer acts to reduce part of any fluctuation in the economy, but does not wipe out 100 per cent of the disturbance. It leaves the rest of the disturbance as a task for fiscal and monetary discretion.

Also read: Role of Fiscal Policy and Monetary Policy


  1. iam confused how tax rates and government expenditures are automatic stabilizer. the are the fiscal policy tools.

  2. The whole thing works through the multiplier theory. Read this in that light. Hope this will clear the confusion.

  3. Thank you for this write up. My textbook's explanation was rather vague, but your post cleared everything up.

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