Optimal Automatic Stabilizers

This paper studies the design of fiscal policies that serve as automatic stabilizers in an incomplete markets economy affected by inefficient business cycle fluctuations. We make three contributions. First, we provide a model that combines nominal rigidities, idiosyncratic income shocks and incomplete markets, but which is sufficiently simple that we can analyze it with an AS-AD diagram to show how sticky prices and incomplete markets interact to determine the effect of and desirability of the automatic stabilizers. Second, we characterize social welfare and show that it depends on the variance of an output gap and inflation as well as on a measure of time-varying inequality. The interaction of nominal rigidities and incomplete markets raises the costs of business cycles making room for stabilization policy to achieve large gains. Third, we calibrate the model to match the main facts about inequality in order to solve for the optimal set of automatic stabilizers. We show that stabilization concerns make the income tax more progressive, unemployment benefits and income support policies more generous.