The following table shows economic information regarding the current year and the forecast for the next year:
GDP Forecast
Year Potential GDP Real GDP Price Level
Present $18.5 trillion $18.5 trillion 114.7
Future Year $20.8 trillion $20.1 trillion 118.3
Should Congress & the President use expansionary or contractionary fiscal policy in the current year? Consistent with this answer, should they raise or lower government purchases? Should they raise or lower taxes?
If Congress & the President succeed in achieving real GDP in the current year that reaches its potential level, will each of the following be higher, lower, or the same in future years as it would have been if they had taken no action (explain each of your answers):
Real GDP
Potential GDP
The inflation rate
The unemployment rate
- Suppose that real GDP is currently $18.1 trillion, potential GDP is $18.5 trillion, the government purchases multiplier is 2.6, and the tax multiplier is -1.5.
Holding other factors constant, how much will government purchases need to increase the economy to equilibrium at potential GDP? Show your calculations and explain.
Holding other factors constant, how much will taxes be cut to bring the economy to equilibrium at potential GDP? Show your calculations and explain.
What is an example of a combination of an increase in government purchases and tax cuts that would bring the economy to equilibrium at potential GDP?
- Suppose the federal budget deficit for the year was $1 trillion, and the economy was in a recession. If the economy had been at potential GDP, it is estimated that tax revenues would have been $120 billion higher and government spending on transfer payments $80 billion lower. Using these estimates, what was the year's cyclically adjusted budget deficit or surplus? Show your calculations and explain.
Full Answer Section
- Potential GDP: It would remain unchanged, as potential GDP is determined by factors like technological advancements, labor force growth, and capital stock.
- Inflation Rate: It might be slightly higher due to increased demand and potential inflationary pressures.
- Unemployment Rate: It would be lower, as the economy is operating closer to full employment.
2. Fiscal Policy Adjustments to Reach Potential GDP
To increase real GDP to potential GDP using government purchases:
- Required increase in government purchases:
- Output gap = Potential GDP - Real GDP = $18.5 trillion - $18.1 trillion = $0.4 trillion
- Government purchases multiplier = 2.6
- Required increase in government purchases = Output gap / Government purchases multiplier = $0.4 trillion / 2.6 ≈ $0.154 trillion or $154 billion
To increase real GDP to potential GDP using tax cuts:
- Required tax cut:
- Output gap = Potential GDP - Real GDP = $0.4 trillion
- Tax multiplier = -1.5
- Required tax cut = Output gap / Tax multiplier = $0.4 trillion / (-1.5) ≈ -$0.267 trillion or $267 billion
A combination of increased government purchases and tax cuts:
- For example, a $100 billion increase in government purchases and a $50 billion tax cut could be a combination that would bring the economy to potential GDP. The exact combination would depend on the specific multipliers and the desired policy effects.
3. Cyclically Adjusted Budget Deficit or Surplus
Cyclically adjusted budget deficit:
- Actual deficit = $1 trillion
- Additional tax revenue if economy were at potential GDP = $120 billion
- Additional government spending on transfers if economy were at potential GDP = $80 billion
- Cyclically adjusted deficit = Actual deficit - Additional tax revenue + Additional government spending = $1 trillion - $120 billion + $80 billion = $900 billion
The cyclically adjusted budget deficit of $900 billion indicates that even if the economy were operating at potential GDP, the government would still have a significant budget deficit. This suggests that the government may need to implement fiscal reforms to address long-term fiscal sustainability.
Sample Answer
Fiscal Policy and Economic Stabilization
1. Fiscal Policy in the Current Year
Given the current economic situation, where Real GDP is equal to Potential GDP, a neutral fiscal policy is appropriate. This means that neither expansionary nor contractionary fiscal policy is necessary.
To maintain this equilibrium, government purchases should remain unchanged, and taxes should also remain unchanged. Any deviation from this neutral stance could potentially destabilize the economy.
If real GDP reaches potential GDP in the current year, the following would happen in future years:
- Real GDP: It would be higher. By closing the output gap, the economy is operating at a higher level of production.