Question

Define the cyclically adjusted budget, explain its significance, and state why it may differ from the actual budget. Suppose the full-employment, noninflationary level of real output is GDP₃ (not GDP₂) in the economy depicted in Figure 13.3. If the economy is operating at GDP₂ instead of GDP₃, what is the status of its cyclically adjusted budget? The status of its current fiscal policy? What change in fiscal policy would you recommend? How would you accomplish that in terms of the G and T lines in the figure?

Short answer

A cyclically adjusted budget is the measurement of the budget status at the full employment level. It compares the actual budget with that at the full employment level. It differs from the actual budget because of the automatic stabilizers.

The cyclically adjusted budget is in surplus.

The current fiscal policy is expansionary.

The government should have an expansionary fiscal policy.

The fiscal policy expansion should occur until the government spending curve and the tax revenue curve meet at GDP₃.

Step-by-step solution

Meaning and significance of cyclically adjusted budget and reason for deviation from actual budget

The cyclically adjusted budget is the estimate of the budget when the economy operates at the full employment level. It is referred to as to cyclically adjusted budget because it eliminates the impact of cyclical changes in the economy and measures the budget status of what it should be in an ideal situation.

A cyclically adjusted budget compares the actual budget status with the full employment situation. It helps to understand how far the actual budget stands from the ideal position and what amount should be adjusted to reach the full employment level of the budget.

A cyclically adjusted budget differs from the actual budget because of the automatic stabilizers. The automatic stabilizers increase the budget deficit in times of recession and decrease the budget deficit during inflation. Therefore, as GDP fluctuates from the equilibrium level, the budget also deviates in the same direction.

Status of the cyclically adjusted budget

The cyclically adjusted budget is the measure of the budget at the full employment level.

The full employment level of the real domestic output is GDP3. The tax revenue at GDP3 is greater than the government spending, which is constant. Thus, the cyclically adjusted budget is in surplus.

Status of current fiscal policy

If Taxes > Government Spending; Contractionary Fiscal Policy.

If Taxes< Government Spending; Expansionary Fiscal Policy.

Since the cyclically adjusted budget is in surplus, the taxes are higher than government spending. Thus the current fiscal policy is contractionary.

Changes in fiscal policy

The actual budget at GDP2is balanced, and the economy is practicing a contractionary fiscal policy. However, the cyclically adjusted budget is in surplus. The government must adopt an expansionary fiscal policy to reach full employment, increasing the GDP and reducing the budget surplus.

Therefore, the economy will be at full employment with a cyclically balanced budget.

Changes in spending and tax curves

To maintain a balanced budget, the government should either increase government spending, decrease taxes, or apply both. The changes in government spending and tax revenue should be such that the line government spending, G, and tax revenue, T, should intersect at full employment, GDP₃.

When tax revenue and government spending curve meet, the cyclical budget will be fully balanced.