Question

Why is the cyclically adjusted budget balance a better measure of whether government policies are sustainable in the long run than the actual budget balance?

Short answer

In the long-run real GDP represent the full employment situation, and cyclically adjusted budget balance removes the effect of the business cycle.

Step-by-step solution

Explanation

The actual budget balance accounts for the effect of the business cycle on the budget deficit. When there is a recessionary gap in the economy, the tax revenue decreases, and the transfer payment increases on the budget; in an inflationary gap in the economy, the tax revenue increases, and the transfer payment decreases on the budget.

The cyclically adjusted budget balance removes the effect of the business cycle, and in the long run, it is assumed that the economy will operate in full employment. Thus, real GDP is full employment; hence, the cyclically adjusted budget balance is better for the long-run sustainable budget balance.