Automatic Stabilizer

It usually act as a balance for the economy so that whenever it faces a recession or an economic breakdown.

Author: Osman Ahmed
Osman Ahmed
Osman Ahmed
Investment Banking | Private Equity

Osman started his career as an investment banking analyst at Thomas Weisel Partners where he spent just over two years before moving into a growth equity investing role at Scale Venture Partners, focused on technology. He's currently a VP at KCK Group, the private equity arm of a middle eastern family office. Osman has a generalist industry focus on lower middle market growth equity and buyout transactions.

Osman holds a Bachelor of Science in Computer Science from the University of Southern California and a Master of Business Administration with concentrations in Finance, Entrepreneurship, and Economics from the University of Chicago Booth School of Business.

Reviewed By: Adin Lykken
Adin Lykken
Adin Lykken
Consulting | Private Equity

Currently, Adin is an associate at Berkshire Partners, an $16B middle-market private equity fund. Prior to joining Berkshire Partners, Adin worked for just over three years at The Boston Consulting Group as an associate and consultant and previously interned for the Federal Reserve Board and the U.S. Senate.

Adin graduated from Yale University, Magna Cum Claude, with a Bachelor of Arts Degree in Economics.

Last Updated:December 24, 2023

What is an Automatic Stabilizer?

Automatic stabilizers usually balance the economy so that the government can induce strategies to overcome it whenever it faces a recession or an economic breakdown.

However, they can also calm the economy whenever it rises. So technically, they work on keeping the development within their control. 

Most of these stabilizers are a form of the fiscal act but can also appear in other states.

During the most significant recession in 2007-08 since World War II, the government tried to overcome the GDP breakdown by imposing acts such as the Economic Stimulus Act of 2008 and the American Recovery and Reinvestment Act of 2009.

Both were fiscal acts aiming at tax cuts and increasing government spending.

  • The Economic Stimulus Act was a tax rebate for low or average-income people. It was implemented to reduce the income tax burden on these people. It was like a refund to compensate the people.
  • The American Recovery and Reinvestment Act of 2009 (ARRA) aimed an increase government spending to balance the drop in private spending. This act focused on the benefit to the citizens by creating jobs and investments.

Key Takeaways

  • The term automatic stabilizer refers to a fiscal policy formulation designed to respond immediately to fluctuations in a country's economic activity.
  • They stabilize income levels, consumption patterns or demand, and business spending and get automatically triggered-without explicit approval.
  • Examples include progressive individual and corporate income taxes, unemployment insurance, welfare, and stimulus assessments.

How does an Automatic Stabilizer work?

The government or Central Bank (CB) usually tries to ensure that the country's GDP is within a specific range so that nothing can occur out of hand.

If the GDP falls below its comprehended range, automatic stabilizers increase it, and if it rises above it, they tend to drop it.

The usual automatic stabilizers are 

Both fall under Keynesian economics theory, which believes that aggregate demand is the leading cause of an economic recession.

According to Keynesian theory, the government must increase its spending or lower the income taxes to help the economy in times of recession. 

Investments can also play a role in the country's GDP, especially nowadays when the GDP of 151 countries relies on assets that make up about 20-25% of the annual GDP. This percentage has been growing over the years.

Though investments can become the number one influencer on GDP, the government needs an effective built-up strategy to make it work.

Especially in times of recession, the government will search for a way that would work, and investments will be based on advertisements and people's satisfaction.

They will instead turn to strategies based on statistics and data.

However, if the economy was on a floating exchange rate, it wouldn't need the government to stabilize it. The exchange rate is an automatic stabilizer and keeps the country within a sure GDP. 

Automatic stabilizers are believed to be more valued in the coming years. A lot has been going on since the pandemic and the Russian invasion. Therefore, some economists believe that a recession is underway, and we must be careful. 

To understand more about what happens in times of crisis, you must understand the shrinkage of cash flow. Check out our course on cash flow modeling.

The formula of Fiscal Rule

Maintaining GDP requires a rule or strategy for which economists follow a particular formula. 

Y = C(Y - T) + I + G + NX

This formula is known as the Fiscal Rule.

Where Y is GDP, C is consumption, I is an investment, G is government spending, and NX is the net exports [exports (EX) - imports (IM)]

We can also deduce that (Y - T) is the disposable income– the number of money people can spend on their needs and save.

The GDP of the country relies on each of these variables. Therefore, the authorities tend to play with these variables to help maintain the GDP at a special rate.

They all have a positive effect on GDP, except for taxes. As T increases, consumption (C) drops, causing the GDP to decrease.

What to do would depend on the actual data or statistics they have. 

For example, if GDP falls and G is already too high, the government wouldn't tend to increase it more. Instead, they might turn to taxes or influence people's investments.

You can check the Federal Reserve for updates on how the government operates daily.

Examples of Automatic Stabilizers

The government has been leaning towards many ways to induce a stabilized economy. Therefore, in times of crisis, they turn to the central bank to increase their money (printing or adjusting the interest rates). 

However, the essential automatic stabilizers are fiscal– taxes and government spending, or the exchange rate that doesn't need the authorization to adjust on its own.

For instance, during the Great Recession, taxes were offset to balance the massive drop in the economy. The government increased its spending whenever it had the chance. 

This action created a stimulus of 1.3% for the economy's GDP. 

However, many economists still doubt the benefits of these fiscal acts, mentioning that they have caused more trouble over the years. In addition, they argue that it slowed the recovery from the Great Recession.

It can't be proven what exactly got the country out of misery between 2009 and 2012, but the government turned towards its fiscal policy because it was a fast escape from the catastrophe.

Tax Cuts

Tax cuts decrease the taxes demanded from the people (drop in T).

A decrease in income taxes will increase the amount of disposable income so that people will have more money in their pockets. This will attract more investors, and it will make hiring and paying employees a more straightforward process.

Going back to the formula: 

Y = C(Y - T) + I + G + NX

Assume there is a drop in the GDP of the economy. A reduction in T will increase consumption and lead to an increase in GDP.

On the other hand, this act will decrease the net government savings (T - G). 

Tax cuts have a more enormous effect than government spending (G) on net government savings (T - G).

The amount of tax revenue made in the US in 2020 is estimated at $3.71 trillion. So if the government only makes a tax cut of 10%, it will lose about $371 million, which might have a negligible effect on the people.

Even though it favors the people, it might be risky for the government. 

Whereas, in other countries with low-income households, tax cuts wouldn't affect the net government savings that badly. 

It also directly affects consumption which will affect the utility of the people. On the other hand, this might benefit the net government savings in such countries as Turkey.

Another type of tax cut is the corporate tax cut which is a tax on firms and corporations.

For instance, in 2017, Donald Trump-induced the Tax Cuts and Jobs Act of 2017, which lowered the corporate tax rate to 20% and increased the GDP growth rate by 0.7%

Considering everything, if a massive increase in GDP occurs, the government increases taxes to decrease consumption.

Increase Government Spending

An increase in government spending might be simple purchases of goods and services by the authorities that benefit the citizens and the country. 

Examples: healthcare, road repairs, school funding, etc.

Whereas in times of recession, the government resorts to compensation. The different types of compensation provided are food and medical supplies or cash to increase disposable income.

In this case, tax cuts or refunds can also be considered a form of compensation since they increase the disposable income of the people.

However, the difference between tax cuts and increased government spending in the form of compensation is

  • Tax cuts will help every country's citizen, even if he is the richest man in the world.
  • Compensations, on the other hand, provide for the people in need, mostly poor people or people who can't pay for surgeries or medical treatments. 

This, ethically, would yield more satisfaction. Comforting the ones who are suffering would push the utility of the country even higher. 

It is known that every person has a diminishing marginal utility, so spending money on the rich sector will not provide enough utility.

This can also benefit the net government savings. 

Helping the needy will not cut taxes on the rich, who create about half the net government savings. Instead, the people will be more satisfied, and the government will lose less money.

Another form of government spending that is very beneficial as an automatic stabilizer is unemployment insurance which provides utility and comfort for the unemployed who can't cover their expenses.

While it benefits the GDP, it can be risky for countries with high unemployment rates, like Africa.

This is also close to retirement insurance which can also be risky in countries with high rates of elderly, like Sweden and Norway.

Going back to the formula: 

Y = C(Y - T) + I + G + NX

Assume there is a decrease in the GDP of the economy. An increase in G will push the GDP upwards.


Floating Exchange Rate

Apart from fiscal policies, a floating exchange rate can sometimes solve problems. 

It all goes back to the trilemma of international finance.


Every country gets to pick only two of these three choices to maintain its economic balance. 

In this case, maintaining a floating exchange rate puts the country at level B, where it can exercise a free capital flow and have a sovereign monetary policy. 

This may yield the power of the country where it has the complete ability to expand its external market (and credit balance) and benefit from outside traders and investment opportunities; it can also create more connections with other countries.

However, many strong countries like China (at level C) have grown powerful over the years. They have a fixed exchange rate but suffer from capital flow.

A floating exchange rate always has its benefits. It can allow the authorities to achieve the internal goals of 

  1. Full employment 
  2. Price stability.

A). A floating exchange rate (E) only adjusts to the DD curve (goods market) and the AA curve (asset market). 

If the DD curve shifts to the right, the demand for goods increases. This increases output, and the exchange rate adjusts by decreasing. 

Moreover, as the exchange rate drops, domestic goods look cheaper than foreign goods, increasing the country's exports and decreasing imports.

This means that the demand for domestic goods will increase, and in this case, their value. 

Consequently, the exchange rate increases, and the currency appreciates.

B). On the other hand, if we are under a fixed exchange rate, the AA curve will also shift to the right causing a huge increase in output. 

Nevertheless, the fact that having a floating exchange rate might easily lead to the risk of devaluation can't be disregarded. Even a country like the US is at risk of losing its currency value.

Here is a video to understand the difference between both exchange rates.

Effects of Automatic Stabilizers

The effects are:

Increase Aggregate Demand

As government spending increases, more goods and services will be provided for people so that they will have fewer costs on them. As a result, the cash flow in the economy will expand since people will have more cash in their pockets.

People most likely buy more than their actual needs implying an increase in consumption (C).

They will also have extra cash to invest, so investments (I) will increase.

This might look like a great way to hold the economy, but expanding the cash flow creates more demand for goods.

According to the formula:

AD = C + I + G + NX

all the variables (C, I, and G) affect AD. They all put huge pressure on AD.


As AD increases, the value of goods compared to the currency rises, which causes prices to go up. This will lead to a devaluation of the currency in the long run. 

For example, the US is a country that has been suffering for the past two years because of its inflation rate. It all started with the Russian invasion of Ukraine, causing a huge increase in demand for products the country cannot supply (pent-up demand).

Even though net exports increased in the US, they still suffered as the aggregate demand outweighed the aggregate supply.

Therefore, an increase in AD causes inflation, especially if the country is under a floating exchange rate like the US. 

The only solution that can be provided here is to create substitutes for these products if they can.

Automatic stabilizers will lead to higher growth in the short term. However, the economy might have some challenges in the long term, and the country can face the risk of losing its currency value.

Researched and authored by Yasmine El Haffar | Linkedin

Reviewed and Edited by Parul Gupta | LinkedIn

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