Question

Last year, while an economy was in a recession, government spending was \(595\) billion dollars and government revenue was 505 billion dollars. 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 \(90\) 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

Calculate Non-Cyclically Adjusted Budget Deficit

To calculate the non-cyclically adjusted budget deficit, subtract the government's revenue from its spending for last year. Thus, it is computed as: \[ 595 \text{ billion dollars} - 505 \text{ billion dollars} = 90 \text{ billion dollars} \] This means the government has a non-cyclically adjusted budget deficit of 90 billion dollars.

Calculate Cyclically Adjusted Budget

For the cyclically adjusted budget, consider the estimated figures if the economy was at full employment. Subtract the full-employment level revenue from full-employment level spending: \[ 555 \text{ billion dollars} - 550 \text{ billion dollars} = 5 \text{ billion dollars} \] This means the government has a cyclically adjusted budget deficit of 5 billion dollars.

Match Calculated Amounts with Statements

Compare the calculated budget deficits with the provided statements: - The non-cyclically adjusted deficit of 90 billion matches statement b. - The cyclically adjusted deficit of 5 billion matches statement e.

Key concepts

Budget Deficit

A budget deficit occurs when a government spends more money than it receives in revenue. In the context of our problem, the government had expenditures of 595 billion dollars and revenues of 505 billion dollars during a recession year. This led to a non-cyclical budget deficit of 90 billion dollars. To understand this better, think of it as if the government is using more resources than it's generating through taxes and other income.

• Government Spending: 595 billion dollars (money going out)
• Government Revenue: 505 billion dollars (money coming in)

Calculating the deficit is straightforward: subtract the revenue from the spending, which gives us the 90 billion dollar gap. This deficit means the government may need to borrow money to cover the shortfall, often by issuing bonds.

Recession

A recession is a period when the economy is not doing well, often marked by a decrease in GDP, employment, and production. During recessions, governments often spend more or reduce taxes to stimulate the economy, consequently increasing the budget deficit. In our example, the economy was in a recession, leading to lower government revenues as businesses and individuals earn less money and pay fewer taxes. Despite these lower revenues, government spending might remain high to support the economy, thus contributing to the budget deficit. This is a typical fiscal policy response intended to dampen the effects of the recession and eventually spur economic growth.

Full Employment GDP

Full Employment GDP is the level of GDP an economy would achieve if it were operating at full capacity, with all resources optimally employed. It represents a goal for economic policy-makers as it indicates no spare capacity or involuntary unemployment. In the exercise, it was projected that had the economy been at full employment, government spending would have been 555 billion dollars, and revenues would have been 550 billion dollars. However, in reality, during the recession, the economy was operating below this level, leading to lower revenues and higher-than-necessary spending. Why is Full Employment GDP important?

• Optimizes use of resources, reducing waste.
• Reflects a healthy economy with minimal unemployment.
• Enables accurate budgeting and fiscal management free from cyclical influences.

Cyclically Adjusted Budget

A cyclically adjusted budget reflects what the budget would be if the economy were operating at full employment. This adjustment provides a clearer picture of the government's fiscal position by filtering out the effects of economic cycles, such as recessions or booms. For the economy in question, the cyclically adjusted budget calculated a deficit of 5 billion dollars. This measure provides insight into the structural aspects of the budget that are independent of fluctuating economic conditions. Key benefits of understanding the cyclically adjusted budget:

• Helps policymakers identify underlying fiscal policies that need correction.
• Assists in distinguishing between temporary and permanent budget issues.
• Guides future fiscal policy decisions by highlighting necessary adjustments.

By analyzing both the non-cyclically and cyclically adjusted budgets, governments can better tailor their fiscal policies to stabilize the economy over the long term.