Check Your Understanding

1. Question

   Why is the cyclically adjusted budget balance a better measure of the long-run sustainability of government policies than the actual budget balance?

   The actual budget balance takes into account the effects of the business cycle on the budget deficit. During recessionary gaps, it incorporates the effect of lower tax revenues and higher transfers on the budget balance; during inflationary gaps, it incorporates the effect of higher tax revenues and reduced transfers. In contrast, the cyclically adjusted budget balance factors out the effects of the business cycle and assumes that real GDP is at potential output. Since, in the long run, real GDP tends to potential output, the cyclically adjusted budget balance is a better measure of the long-run sustainability of government policies.

2. Question

   Explain why states required by their constitutions to balance their budgets are likely to experience more severe economic fluctuations than states that are not held to that requirement.

   In recessions, real GDP falls. This implies that consumers’ incomes, consumer spending, and producers’ profits also fall. So in recessions, states’ tax revenue (which depends in large part on consumers’ income, consumer spending, and producers’ profits) falls. In order to balance the state budget, states have to cut spending or raise taxes, but that deepens the recession. States without a balanced-budget requirement don’t have to take steps that would make things worse during a recession, and they can use expansionary fiscal policy to lessen the fall in real GDP.

3. Question

   Explain how each of the following events would affect the public debt or implicit liabilities of the U.S. government, other things equal. Would the public debt or implicit liabilities be larger or smaller if they occurred?

   1. The growth rate of real GDP increases.

      A higher growth rate of real GDP implies that tax revenue will increase. If government spending remains constant and the government runs a budget surplus, the size of the public debt will be less than it would otherwise have been.

   2. Retirees live longer.

      If retirees live longer, the average age of the population increases. As a result, the implicit liabilities of the government increase because spending on programs for older Americans, such as Social Security and Medicare, will rise.

   3. Tax revenue decreases.

      A decrease in tax revenue without offsetting reductions in government spending will cause the public debt to increase.

   4. The government borrows to pay interest on its current public debt.

      Public debt will increase as a result of government borrowing to pay interest on its current public debt.

4. Question

   Suppose the economy is in a slump and the current public debt is quite large. Explain the trade-off of short-run versus long-run objectives that policy makers face when deciding whether or not to engage in deficit spending.

   In order to stimulate the economy in the short run, the government can use fiscal policy to increase real GDP. This entails borrowing, increasing the size of public debt further and leading to undesirable consequences: in extreme cases, governments can be forced to default on their debts. Even in less extreme cases, a large public debt is undesirable because government borrowing “crowds out” borrowing for private investment spending. This reduces the amount of investment spending, reducing the long-run growth of the economy.