What is the role of the automatic stabilizers in the U.S. business cycle?

Ricardo Reis and Alisdair McKay

No 1116, 2012 Meeting Papers from Society for Economic Dynamics

Abstract: Every developed country has automatic rules in its tax-and-transfer system that are, at least partly, intended to stabilize economic fluctuations. While there is great dispute on whether discretionary fiscal policy can be used as a countercyclical policy, there is wide agreement that these automatic stabilizers are effective. We re-evaluate this conclusion by studying the role of the main economic stabilizers in a modern business-cycle model. Our model has roles for aggregate demand, as in Keynesian theories, as well as for intertemporal labor supply and capital accumulation, as in neoclassical theories. Moreover, there is household heterogeneity and incomplete financial markets, so that redistribution resources affects macroeconomic aggregates. Our first finding is that this last ingredient is crucial: without it, the automatic stabilizers have a negligible effect on the volatility of economic activity. Our second finding is that, in the existing tax code and transfer system, some feature attenuate the business cycle but others accentuate it; overall, the effect is stabilizing but only mildly. Our third finding is that, with some small changes to some social programs, our model predicts that the automatic stabilizers could be much more effective.

Date: 2012
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