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Principles of Economics 2e

2nd Edition
Steven A. Greenlaw; David Shapiro
ISBN: 9781947172364

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BuyFindarrow_forward

Principles of Economics 2e

2nd Edition
Steven A. Greenlaw; David Shapiro
ISBN: 9781947172364
Textbook Problem

Explain how automatic stabilizers work, both on the taxation side and on the spending side, first in a situation where the economy is producing less than potential GDP and then in a situation where the economy Is producing more than potential GDP.

To determine

When the economy is producing less than potential level of GDP and when the economy is producing more than potential level of GDP, the way automatic stabilizers work from spending and tax side.

Explanation

Automatic stabilizers are economic parameters that act automatically to counter the fluctuations in GDP. It means the automatic stabilizers increase aggregate demand in periods of economic slowdown and decrease aggregate demand in periods of economic boom. Some examples of economic stabilizers are government spending, taxes, unemployment insurance, food stamps, etc.

In times when the economy is producing less than potential GDP, the response of the government would be an expansionary fiscal policy. An expansionary fiscal policy of the government refers to the use of government spending to increase the aggregate demand, output, employment and prices in the economy. It includes:

  1. cuts in business taxes to increase after tax profits.
  2. cuts in individual income taxes to increase the disposable income and hence to increase the consumption.
  3. increasing government purchases of final goods and services to increase aggregate demand directly.

However, automatic stabilizers also work in the same way without the use of discretionary fiscal policy. On the spending side, a reduced aggregate demand would mean higher unemployment and weak domestic demand which would stimulate government expenditure on unemployment insurance, public works, welfare schemes, etc. On the tax side, a low aggregate demand would mean lower personal income, corporate profits and thus lower taxes payable...

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