Question

What is the cyclically adjusted budget deficit or surplus? Suppose that real GDP is currently at potential GDP, and the federal budget is balanced. If the economy moves into a recession, what will happen to the federal budget?

Short answer

If the economy moves into a recession from a state where real GDP is at potential GDP and the federal budget is balanced, the federal budget is expected to move into a deficit. This is due to decreased tax revenues and potentially increased government expenditures. The cyclically adjusted budget would also show a deficit.

Step-by-step solution

Understanding Key Terms

The cyclically adjusted budget deficit or surplus, also known as the full-employment deficit, measures what the deficit or surplus would be if the economy was at its potential level of GDP. It’s calculated by adjusting the actual budget deficit by the impact of the deviation of actual GDP from potential GDP.

Understanding the Current Situation

Given the real GDP is currently at the potential GDP level, it implies that the economy is neither in a recession nor experiencing inflation. Also, the federal budget is balanced, meaning government revenues are equal to its expenses.

Effects of Recession

If the economy moves into a recession, real GDP decreases. With less income being earned by individuals and businesses, tax revenues of the federal government can decrease. As the government often increases spending to stimulate the economy during a recession (for example on unemployment benefits or infrastructure projects), government expenditures can increase. This leads to a budget deficit.

Conclusion

In case of a recession, the federal budget would move from its balanced state towards a deficit. The cyclically adjusted budget would also show a deficit, reflecting the economic downturn.

Key concepts

Potential GDP

Understanding the concept of potential GDP is fundamental when discussing any nation's economic health. Potential GDP, often referred to as full-employment GDP, is the maximum output an economy can sustain over the long term without causing inflation. This does not mean every individual is working, but rather that the economy operates at an optimal employment level accounting for normal unemployment.

It's like a speedometer in a car – potential GDP is the safe, top speed that the car can handle without damaging the engine, so to speak. Economies fluctuate around this level, sometimes speeding up, sometimes slowing down. When actual GDP matches potential GDP, the economy is said to be in balance, utilising resources efficiently without overheating.

Governments monitor this because it helps them make decisions on fiscal policy. If actual GDP is below potential GDP, it's an indication that the economy has room to grow; the gears can shift up to drive towards that top sustainable speed without risks of inflation or economic strain.

Government Fiscal Policy

Government fiscal policy is a powerful steering wheel that helps guide the economy's direction. It involves adjusting government spending and taxation to influence the nation's economic activity. Fiscal policy can be 'expansionary' or 'contractionary'.

In an expansionary fiscal policy, the government spends more than it collects in taxes, typically to stimulate growth during economic turndown. A contractionary fiscal policy, on the other hand, involves reducing government spending or increasing taxes to slow down the economy when it's growing too fast, which could lead to inflation.

Imagine fiscal policy is like watering a plant; too little water and the plant wilts (recession), but too much and it can drown (inflation). The intricate balance of fiscal policy depends on accurate measures of parameters like the potential GDP to determine what the economy needs – a gentle sprinkle or withholding water for a bit.

Economic Recession

Think of an economic recession as a season where a country's economy starts to cool after a period of growth, just as summer turns to fall. An official recession is typically defined as two consecutive quarters of negative GDP growth. During a recession, businesses produce less, unemployment rises, consumer spending decreases, and economic confidence wanes.

It's similar to trees in autumn, shedding their leaves — the economy sheds some of its activity. Companies may hire less or lay off workers, consumers may tighten their wallets, and the ripple effect can be felt throughout the economy.

Due to these challenges, a country's fiscal policy becomes even more critical. Tactics like lowering taxes or increasing government spending work to reignite the economy, hoping to bring the spring back after the cold snap of the recession. Understanding the recession's dynamics is key to crafting fiscal policies that effectively respond to economic downturns and facilitate a recovery towards potential GDP.