Question

Suppose the economy is having a recession following a price shock from high oil prices. Verbally explain how both income taxes and (variable) import spending can act as automatic stabilizers.

Answer 1

In the recession caused by a price shock from high oil prices, the aggregate supply curve of the economy will shift leftwards and this will cause an increase in the price level and reduction in the level of national output in the economy. A reduction in the level of national output will reduce overall income level in the economy and this will lead to a reduction in the income taxes which are proportionate to income level and thus level of income taxes decrease and variable import spending which also depends on income level in the economy will reduce. This reduction in the level of income taxes and import spending will increase the level of aggregate demand in the economy and the rightward shift of the aggregate demand will move the economy to full employment level. Thus, income taxes and variable import spending act as automatic stabilizers in the economy.