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How do taxes and transfer payments work as automatic fiscal policy to dampen the business cycle?...

How do taxes and transfer payments work as automatic fiscal policy to dampen the business cycle?

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Answer #1

Taxes and transfer payments are known as Automatic Stabilizers which moderate the business cycle shock.

During recession (expansion), taxable income is low (high), therefore tax also is lower (higher), which mitigates the economic shock caused by lower (higher) income, thereby the fall (rise) in real GDP does not go beyond control. Similarly, during recession (expansion), because of lower (higher) income of people, the government needs to spend higher (lower) amount as transfer income, which increases (decreases) disposable income, thereby moderating the shock caused by the recession (expansion).

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