Question

An economy is in a recession with a large recessionary gap and a government budget deficit. a. Is the government budget deficit a structural deficit or a cyclical deficit? Explain. b. Explain how automatic fiscal policy is changing the output gap. c. If the government increases its discretionary expenditure, explain how the structural deficit might change.

Short answer

a. The deficit is a cyclical deficit. b. Automatic fiscal policies mitigate the output gap by increasing spending and reducing taxes. c. Increased discretionary expenditure can initially raise the structural deficit but may reduce it in the long run if the economy improves.

Step-by-step solution

Identifying the Budget Deficit

A government budget deficit during a recession with a large recessionary gap is primarily caused by cyclical factors. A cyclical deficit is a temporary shortfall that occurs because of the economic downturn, where tax revenues fall and government spending on benefits like unemployment insurance rises.

Impact of Automatic Fiscal Policy

Automatic fiscal policies are mechanisms like unemployment benefits and progressive taxes that automatically respond to economic changes without additional government action. During a recession, these policies increase government spending (unemployment benefits) and reduce taxes (as incomes fall), which helps to cushion the downturn and reduce the output gap.

Effect of Increased Discretionary Expenditure

Discretionary expenditures are deliberate actions taken by the government to influence the economy, such as public works or tax cuts. Increasing government discretionary spending can lead to a temporary rise in the structural deficit, but it aims to boost economic activity, increasing aggregate demand and potentially reducing the recessionary gap.

Structural Deficit Changes

If the government increases discretionary spending, in the short term, the structural deficit may rise as spending increases without an immediate increase in revenue. However, if this spending successfully boosts the economy, tax revenues may eventually increase, reducing the structural deficit in the long term.

Key concepts

Cyclical Deficit

A cyclical deficit occurs during periods when the economy is not performing at its full potential. In the case of a recession, economic activities slow down, unemployment rises, and businesses earn less. Consequently, tax revenues fall because people and businesses aren’t making as much money.
At the same time, government spending increases because more people rely on unemployment benefits and other social programs. This type of deficit is temporary and is directly related to the economic cycle.
The good news is that as the economy recovers, the cyclical deficit generally shrinks on its own.

• Recession: Decline in economic activities.
• Tax Revenues Drop: Lower income leading to less tax collected.
• Increased Government Spending: More outlays on social benefits.
• Temporary: Deficit improves as the economy regains strength.

Automatic Fiscal Policy

Automatic fiscal policy refers to the built-in governmental policies that automatically help stabilize the economy during fluctuations without direct intervention from policymakers. These policies include tax systems where taxes decrease as earnings fall, and unemployment benefits that increase as more people lose jobs.
During a recession, these mechanisms work to pump more money into the economy, providing a cushion that lessens the recession's impact. This automatic response helps reduce the output gap—the difference between the economy's actual and potential output.

• Automatic Stabilizers: Policies that respond on their own.
• Tax System: Taxes fall when incomes fall, increase when incomes rise.
• Unemployment Benefits: More benefits paid as job losses increase.
• Reduced Output Gap: Minimizes the disparity between actual and potential economic output.

Discretionary Expenditure

Discretionary expenditure involves intentional government spending or tax policies designed to influence economic activity. Unlike automatic fiscal policies, these require explicit government action such as new legislation.
For instance, during a recession, the government might decide to build infrastructure or cut taxes to stimulate the economy. This can increase aggregate demand, encouraging businesses to produce more and hire more people. Initially, these actions may raise the structural deficit, but by boosting economic activity, they can lead to higher tax revenues in the future.

• Government Actions: Direct decisions to spend or alter taxes.
• Stimulus: Aimed at jumpstarting the economy.
• Infrastructure Projects: Example of discretionary spending.
• Short-term Deficit Increase: Higher expenses before earnings rise.

Structural Deficit

A structural deficit means the government’s budget deficit remains even when the economy is at its full potential. This happens when routine government spending exceeds revenues regardless of the economic cycle.
While cyclical deficits are temporary, structural deficits can persist and may require government intervention, such as increasing taxes or reducing public spending, to bring the budget back in balance.
A structural deficit can become burdensome and may impact long-term economic stability if not addressed.

• Persistent Deficit: Exists even in a strong economy.
• Routine Overspending: Regular expenses exceed income.
• Government Interventions: May need policy changes to fix.
• Long-term Impact: Can affect economic stability over time.