Question

Last year, while an economy was in a recession, government spending was 595 billion dollars and government revenue was S505 billion. Economists estimate that if the economy had been at its full-employment level of GDP last year, government spending would have been 555 billion dollars and government revenue would have been 550 billion dollars . Which of the following statements about this government's fiscal situation are true? a. The government has a non-cyclically adjusted budget deficit of 595 billion dollars . b. The government has a non-cyclically adjusted budget deficit of 90 billion dollars . c. The government has a non-cyclically adjusted budget surplus of S90 billion dollars . d. The government has a cyclically adjusted budget deficit of 555 billion dollars . e. The government has a cyclically adjusted budget deficit of 5 billion dollars . f. The government has a cyclically adjusted budget surplus of 5 billion dollars .

Short answer

Statements b and e are true.

Step-by-step solution

Determine Non-Cyclically Adjusted Budget Deficit or Surplus

The non-cyclically adjusted budget, or the actual budget, reflects the government's current spending and revenue. Given:- Government Spending: \(595 billion- Government Revenue: \)505 billionCalculate the non-cyclically adjusted budget deficit:\[\text{Deficit} = \text{Spending} - \text{Revenue} = 595 - 505 = 90 \text{ billion dollars}\]Thus, the government has a non-cyclically adjusted budget deficit of 90 billion dollars.

Determine Cyclically Adjusted Budget Deficit or Surplus

The cyclically adjusted budget assumes the economy is at full-employment. Given:- Full-employment Government Spending: \(555 billion- Full-employment Government Revenue: \)550 billionCalculate the cyclically adjusted budget deficit:\[\text{Deficit} = \text{Full-Employment Spending} - \text{Full-Employment Revenue} = 555 - 550 = 5 \text{ billion dollars}\]Thus, the government has a cyclically adjusted budget deficit of 5 billion dollars.

Evaluate the Statements

Based on our calculations: - The non-cyclically adjusted budget deficit is $90 billion, so statement b is true. - The cyclically adjusted budget deficit is $5 billion, so statement e is true. None of the other statements align with our calculated results.

Key concepts

Budget Deficit

A budget deficit occurs when a government's expenditures exceed its revenues within a specific period, typically a fiscal year. In the context of the exercise, the government spending was $595 billion, while the revenue was only $505 billion. This resulted in a deficit calculated as follows:

• Spending: $595 billion
• Revenue: $505 billion
• Deficit: $595 billion - $505 billion = $90 billion

The deficit essentially means that the government had to borrow money to cover its expenses since its income from taxes and other sources was insufficient. Budget deficits can occur due to various factors such as increased government spending during economic downturns, like the recession mentioned in the exercise, or a decrease in tax revenues as economic activity slows down.
Understanding the concept of a budget deficit is crucial for comprehending fiscal policy and how governments manage their economies during different phases of economic cycles.

Cyclically Adjusted Budget

The cyclically adjusted budget helps to analyze a government's fiscal position under the assumption of full employment. This metric strips out the temporary effects of the economic cycle, providing a clearer view of the underlying fiscal balance. In the exercise, we consider a scenario where the economy operates at full employment:

• Full-employment Government Spending: $555 billion
• Full-employment Government Revenue: $550 billion
• Deficit at Full Employment: $555 billion - $550 billion = $5 billion

The goal of evaluating a cyclically adjusted budget is to determine the sustainable level of government spending and revenue without the influence of economic booms or recessions. It is particularly useful for policymakers to understand if current fiscal policies are structurally balanced or if adjustments are needed to stabilize the economy in the long term.
By focusing on this adjusted budget, we see that even without the cyclical downturns, a small deficit still exists, indicating potential structural imbalances.

Full Employment GDP

Full Employment GDP, also known as potential GDP, refers to the maximum level of economic output that can be sustained over the long term without leading to inflation. This concept assumes that all available labor and capital resources are used efficiently. In the exercise, economists estimated the economy's full employment scenario to guide fiscal assessment:

• Full-employment output doesn't imply a zero unemployment rate but rather a natural rate where unemployment is due primarily to factors like job transitions.
• Assessing budgets at Full Employment GDP shows how much the government should ideally be spending and collecting in revenues.
• It helps identify discrepancies in actual fiscal policies versus what the economy could support sustainably.

Understanding Full Employment GDP is essential for evaluating the fiscal health of an economy independently of short-term volatility. When government budgets are assessed against Full Employment GDP, it offers insights into whether a government's fiscal stance is inherently expansionary or contractionary. This, in turn, influences decisions on managing public debt and planning future spending and taxation policies.