Question

In a given economy, households save \(10 \%\) of their incomes; the current income tax burden is \(25 \%\); planned investments are expected to be \(\$ 60\) billion; and the trade deficit is about \$2.5 billion. Current government expenditures are \(\$ 270\) billion per year. The full capacity GNP level is \(\$ 1,060\) billion. What is the current deficit? What is the full employment deficit? Compare the two. Is the current budget expansionary or contractionary ? Explain.

Short answer

The current deficit is \(\$332.5\) billion - \(0.925(\$1,060\text{ billion})\) and the full employment deficit is the same, \(\$332.5\) billion - \(0.925(\$1,060\text{ billion})\). Since the current deficit and the full employment deficit are equal, the current budget neither expansionary nor contractionary.

Step-by-step solution

Calculate total spending in the economy

First, we need to find out the total spending in the economy. In this case, total spending consists of planned investments, government expenditures, and trade deficit. Planned investments: \(60\) billion Government expenditures: \(270\) billion Trade deficit: \(2.5\) billion Total spending = Planned investments + Government expenditures + Trade deficit Total spending = $60 + 270 + 2.5 = \(\$332.5\) billion

Calculate total revenue in the economy

To find the total revenue in the economy, we need to consider both the income tax burden and households' savings. We are given that households save \(10\%\) of their incomes and the current income tax burden is \(25\%\). Let's represent the total income before tax as \(I\). Then, the total income after tax would be: Income after tax = \(I - 0.25I = 0.75I\) Households save \(10\%\) of their incomes, so the total savings would be: Total savings = \(0.10\times 0.75I = 0.075I\) Since households spend the remaining amount from their after-tax income, total consumption would be: Total consumption = Income after tax - Total savings Total consumption = \(0.75I - 0.075I = 0.675I\) Now, we can find the total revenue in the economy, which is the sum of household consumption and government income (income taxes): Total revenue = Total consumption + Income tax Total revenue = \(0.675I + 0.25I = 0.925I\)

Calculate the current deficit

Now we can calculate the current deficit in the economy by finding the difference between the total spending and total revenue: Current deficit = Total spending - Total revenue Current deficit = \(\$332.5\) billion - \(0.925I\)

Calculate the full employment deficit

We are given that the full capacity GNP level is \(\$1,060\) billion. At full employment, the total income (\(I\)) would be equal to the full capacity GNP: Full capacity GNP = \(I\) \(I = \$1,060\) billion Now, we can calculate the full employment deficit using the total spending and the total revenue at full capacity GNP: Full employment deficit = Total spending - Total revenue at full capacity Full employment deficit = \(\$332.5\) billion - \(0.925(\$1,060\text{ billion})\)

Compare the current deficit and the full employment deficit

We can now compare the current deficit and the full employment deficit to determine whether the current budget is expansionary or contractionary. We can compare them by looking at their numerical values: Current deficit = Total spending - \(0.925I\) Current deficit = \(\$332.5\) billion - \(0.925(\$1,060\text{ billion})\) Full employment deficit = \(\$332.5\) billion - \(0.925(\$1,060\text{ billion})\) If the current deficit is greater than the full employment deficit, the current budget is expansionary. If the current deficit is less than the full employment deficit, the current budget is contractionary.

Key concepts

Budget Deficit

The term 'budget deficit' is when a government spends more money than it receives in revenues, like taxes, within a specific period. This shortfall between spending and revenue can cause a government to borrow money. A budget deficit is seen as expansionary if it aims to boost economic activity during slow growth periods.

When governments run a deficit, it usually indicates they are spending on public services, infrastructure, or to stimulate the economy. In times of economic downturns, running a deficit can be beneficial. It pumps money into the economy, encouraging businesses to invest and consumers to spend more, thus boosting overall economic activity.

• Increased spending without matching revenue through taxes contributes to a deficit.
• Deficit financing is borrowing to cover shortfalls, like issuing government bonds.

Understanding whether a deficit is aiding or hurting the economy depends on whether it's compared to full employment levels. A deficit is considered expansionary if it exceeds the potential revenue at full employment since it indicates more spending intended to boost the economy.

Government Spending

Government spending includes all expenses the government incurs for providing public services like education, healthcare, defense, and infrastructure improvements. It’s a significant part of fiscal policy, which uses spending and taxation to influence the economy.

This spending stimulates economic activity by putting money directly into the hands of citizens and businesses. When the government spends money on infrastructure projects, it creates jobs and increases demand for materials and services, leading to economic growth.

• Expenditure on public infrastructure can lead to long-term economic growth.
• Short-term increases in spending can boost economic activity during recessions.

Excessive government spending without increased revenues can lead to high deficits, requiring borrowing. Carefully planned government spending is essential to maintaining economic stability without excessive borrowing.

Taxation

Taxation refers to how governments finance their activities by collecting money from citizens and businesses. These funds are essential for funding government operations and public services.

The income tax is a primary revenue source where a percentage of individual or corporate earnings goes to the government. Taxation can influence economic behavior, with high tax rates potentially discouraging spending and investment. However, well-structured taxes ensure a fair distribution of wealth and provide essential services.

• Progressive taxation imposes higher rates on higher income brackets, aiming for equity.
• Regressive taxes apply the same rate regardless of income, often burdening lower-income earners.

Finding the right balance is critical. Lower taxes can boost disposable income and spending, while higher taxes, if used efficiently, can fund necessary public projects and services. The challenge lies in setting tax rates that optimize economic growth while ensuring adequate revenue.