How do automatic stabilisers cushion the impact of income shocks on household demand?
The extent to which automatic stabilisers mitigate the impact of income shocks on household demand depends on two factors. The first is how a given shock to gross income translates into a change in disposable income. A 40% income tax rate, for instance, will absorb 40% of the shock to gross income as this income would have been taxed anyway. We refer to this effect as “disposable income stabilisation”. The second factor is the link between current disposable income and current demand for goods and services. If the income shock is perceived as transitory, yet current demand depends on some concept of permanent income, their demand will not change, and there is no role for automatic stabilisers. But if households are liquidity constrained, their current expenditures do depend on disposable income. In this case, automatic stabilisers play a role for household demand. Using information on household characteristics to estimate the prevalence of liquidity constraints, we are able to calculat
