Automatic Stabilizers

During a downturn, federal income tax receipts fall and unemployment benefit payments rise without Congress enacting anything new. This effect is best described as:

1. A.Monetary policy operating through the reserves of the banking system.Wrong. Neither the tax receipts nor the benefit payments involve reserves, credit conditions or any action by the Fed.
2. B.Discretionary fiscal policy enacted in response to the business cycle.Wrong. Discretionary means a new law or appropriation, and by hypothesis Congress enacted nothing.
3. C.An automatic stabilizer built into fiscal programs already in force.Correct. Existing tax and benefit rules cushion demand automatically as incomes and employment fall.
4. D.A leading indicator signaling the coming phase of the business cycle.Wrong. These flows respond to a downturn already under way rather than pointing ahead to one.

Why: Fiscal policy operates in two modes. Discretionary policy requires a fresh decision, such as enacting a tax cut or appropriating money for a program. Automatic stabilizers are built into laws already on the books: a progressive income tax collects less as incomes fall, and benefit programs pay out more as unemployment rises, both without any vote. The effect cushions the downturn immediately, which is why it escapes the legislative delay that dogs discretionary action.

As an economy slides into recession, income tax receipts fall faster than national income while unemployment insurance outlays rise, all without any new legislation being enacted. These effects are best described as:

1. A.Discretionary fiscal policyDiscretionary policy requires Congress to enact a new measure, which the facts exclude.
2. B.Automatic stabilizersCorrect. A progressive tax system and transfer programs cushion the cycle without new legislation.
3. C.Open market operationsOpen market operations are a monetary tool executed by the Fed, not a tax and transfer effect.
4. D.Crowding outCrowding out describes government borrowing displacing private investment, a different mechanism.

Why: Automatic stabilizers are features already embedded in the tax and transfer system that moderate the business cycle without any new legislative action. A progressive income tax collects proportionally less as incomes fall, and transfer programs such as unemployment insurance pay out more as joblessness rises, so both cushion aggregate demand automatically. Discretionary fiscal policy, by contrast, requires Congress to pass a new tax or spending measure and therefore arrives with a legislative lag.