Which one of the following functions as an automatic stabilizer in the context of fiscal and monetary policies of an economy?

Correct — A, Personal income tax. An automatic stabiliser is a feature of the budget that damps the business cycle by itself, with no fresh decision by government or central bank. A progressive personal income tax does this in both directions. When incomes rise in a boom, tax collections rise more than proportionately and take spending power out of the economy; when incomes fall in a downturn, liabilities drop and households retain more of what they earn. Unemployment benefits and other transfers work the same way, rising automatically when the economy weakens. Nothing has to be announced for either to operate.

• (b)Reverse repo rate of bank — The reverse repo rate is set by the Reserve Bank of India in its monetary policy decisions. Changing it is a deliberate act of policy, which is the opposite of automatic.
• (c)Open market operation — An open market operation is the central bank deciding to buy or sell government securities to adjust liquidity. It is discretionary by definition.
• (d)Bond price — The price of a bond is a market outcome that moves inversely with the interest rate. It is a signal rather than an instrument, and nobody sets it as policy.

Fiscal policy comes in two forms. Discretionary policy needs a decision — a new tax rate, a spending programme, a stimulus package. Automatic stabilisers are already written into the system and respond to the state of the economy on their own, chiefly through a progressive tax structure and through transfer payments that expand when incomes fall. Monetary instruments such as the repo and reverse repo rates, open market operations and the cash reserve ratio are all discretionary, since each requires the central bank to act.

Sort the four options by who has to do something. Three of them need a decision by the Reserve Bank or reflect what the market has decided, and one operates by itself as incomes move. That single test settles the question without any theory of stabilisation. It is worth adding that the stabilising effect is strongest where the tax is progressive, because the average rate then rises with income and the automatic brake is proportionally larger in a boom.

• An automatic stabiliser damps cyclical fluctuations without any new policy decision.
• A progressive personal income tax and unemployment or welfare transfers are the standard examples.
• Repo and reverse repo rates, open market operations and the cash reserve ratio are discretionary monetary instruments.
• Discretionary fiscal policy includes tax rate changes and new spending programmes announced by government.
• Bond prices move inversely with interest rates and are an outcome rather than an instrument.

• Treating any tax as an automatic stabiliser; the stabilising effect depends on progressivity.
• Confusing monetary instruments with fiscal ones.
• Assuming that because the reverse repo rate changes often, it changes by itself.

A one-line definition item; UPSC has asked the neighbouring idea through the contents of a discretionary fiscal stimulus package, which is the deliberate counterpart of this mechanism.

• practice — not a real PYQ

  Which one of the following acts as an automatic stabiliser during a recession?

  • (a)A rise in the cash reserve ratio
  • (b)Unemployment benefit payments
  • (c)Sale of government securities in the open market
  • (d)An increase in the repo rate

  Answer(b) Unemployment benefit payments — they expand on their own as incomes fall, supporting demand.

• practice — not a real PYQ

  The repo rate in India is decided by

  • (a)the Ministry of Finance
  • (b)the Monetary Policy Committee of the Reserve Bank of India
  • (c)the Securities and Exchange Board of India
  • (d)the Finance Commission

  Answer(b) the Monetary Policy Committee of the Reserve Bank of India — which makes it a discretionary instrument.