Question

Last year, while a hypothetical economy was in a recession, government spending was \(595 billion, and government revenue was \)505 billion. Economists estimate that if the economy had been at its full employment level of GDP last year, government spending would have been \(555 billion and government revenue would have been \)550 billion. Which of the following statements about this government’s fiscal situation are true?

1. The government has a non–cyclically adjusted budget deficit of \(595 billion.

2. The government has a non–cyclically adjusted budget deficit of \)90 billion.

3. The government has a non–cyclically adjusted budget surplus of \(90 billion.

4. The government has a cyclically adjusted budget deficit of \)555 billion.

5. The government has a cyclically adjusted budget deficit of \(5 billion.

6. The government has a cyclically adjusted budget surplus of \)5 billion.

Short answer

Option (e): The government has a cyclically adjusted budget deficit of $5 billion.

Step-by-step solution

Meaning of cyclically adjusted budget

A cyclically adjusted budget is a method to compare the fluctuations in revenue to that level achieved under a full employment situation. The revenue of an economy changes according to its GDP.

When GDP falls, revenue also falls. Through a cyclically adjusted budget, economists measure what the federal budget should be under the full employment situation. The cyclically adjusted budget is also called the full-employment budget.

Explanation for the answer

The government revenue has declined as the government spending, or GDP declined due to the recession creating a budget deficit of $90 billion (=595-505). If the impact of the cyclical phenomenon was eliminated and the economy was at the full employment level, the budget deficit must vary from $90 billion.

Under the full employment situation, the budget deficit (spending revenue) would have been $5 billion only (=555-550). Therefore, the government’s fiscal position has a cyclically adjusted budget deficit of $5 billion.

Hence, option (e) is correct.