Automatic stabilizers | National income and price determination | AP Macroeconomics | Khan Academy

So what we have depicted in this diagram is the business cycle that we have looked at in other videos. This horizontal axis is time; the vertical axis is real GDP. What we see in this dark blue color, you can view that as full employment output at different points in time, and you can see that it is growing. So, this economy is experiencing economic growth. Maybe its population is increasing; they're getting more productive, maybe with better education or with better technology.

But we know that real economies don't just have this nice clean economic growth. They tend to cycle around their full employment output. There are times when they're above the trend line, like right over here; you have a positive output gap. So, this is a positive output gap at that point right over there, and you can also have negative output gaps. We also talked in other videos about fiscal policy. These are the tools that governments might use in order to close these output gaps.

For example, when you have a positive output gap, a government might be afraid that things are overheating. Maybe they're afraid of inflation; they might have contractionary fiscal policy. They might try to do something for that moment in time to close that gap a little bit. More likely, when there is a negative output gap and people are out of work, the government might say, "Hey, let's pass a stimulus package explicitly to try to close this gap. Let's lower taxes; let's increase government spending." That type of fiscal policy, where the government is doing something special for that circumstance in order to close that output gap, that is discretionary fiscal policy.

What we're going to focus on in this video are automatic stabilizers. These are things that people don't have to take special action based on the circumstances in order for them to help smooth out the business cycle. So, automatic stabilizers — so what are examples of automatic stabilizers? One common one is taxes.

So pause this video for a second and think about how do taxes help smooth out these fluctuations. Let's think about what's happening at a part of the business cycle where the economy is expanding. Let's say right over there or let's say right over here. What would be happening with taxes? Well, in these realities with this positive output gap, you could imagine people's incomes are going to get higher and higher. Corporate profits are going to be more and more, and so our change in taxes is going to be positive.

Not only is it going to be positive; not only are your taxes going to increase in absolute dollar terms, but they're probably going to grow at a faster rate than the economy. Why is that? When the economy turns positive, when you start expanding, more and more corporations are going to become profitable. If you think about personal income taxes, below certain incomes in a lot of countries, you don't even have to pay income taxes.

For every incremental dollar or every incremental 10,000, the tax rate on that incremental chunk could go up. That’s why the absolute dollar amount of taxes will likely increase at a faster rate than the actual economic growth. Now let's think about the other scenario; let's think about what taxes do when we are in a recession. So let's say we pick that place right over there. Well, in this situation, corporate profits are going to be lower.

In fact, some corporations are going to become unprofitable, in which case they wouldn't pay corporate taxes. People are going to make less and less money, so your change in taxes here is going to be likely to be negative. Once again, your rate of decrease in taxes is likely to be greater than your rate of decrease of real GDP. The tax multiplier is negative, and so it might smooth out the curve a little bit.

Now another example of an automatic stabilizer would be things like welfare payments or unemployment insurance. Why would these be automatic stabilizers? Well, when times are good, when you have this positive output gap, fewer and fewer people are going to need welfare or they're going to need unemployment payments.

In that world, that is like a decrease in government spending. The government's not going to have to pay for these benefits, and so a decrease in government spending, that’s contractionary, and so that'll help smooth out the curve a little bit. Once again, when we go into our recession, and then when we start having our negative output gaps, more people are going to be on welfare. More people are going to need their unemployment benefits, and so that's going to increase government spending, which might, with the multiplier, smooth out this curve a little bit.

So the big takeaway is this: when the government does something explicitly for the time they are in order to smooth out the curve, that's discretionary fiscal policy. But you might have things in the system, the existing tax policy, existing laws around welfare or unemployment insurance or other benefits that might have an effect regardless of where we are in the business cycle. They have a dampening effect; they try to smooth out these oscillations a little more. They would be automatic stabilizers.