What do we mean by surpluses and deficits? The budget balance, which we defined in Chapter 10, is the difference between the government’s revenue, in the form of tax revenue, and its spending, both on goods and services and on government transfers, in a given year. That is, the budget balance—savings by government—is defined by Equation 13-2 (which is the same as Equation 10-7):

where T is the value of tax revenues, G is government purchases of goods and services, and TR is the value of government transfers. As we learned in Chapter 10, a budget surplus is a positive budget balance and a budget deficit is a negative budget balance.

Other things equal, expansionary fiscal policies—increased government purchases of goods and services, higher government transfers, or lower taxes—reduce the budget balance for that year. That is, expansionary fiscal policies make a budget surplus smaller or a budget deficit bigger. Conversely, contractionary fiscal policies—reduced government purchases of goods and services, lower government transfers, or higher taxes—increase the budget balance for that year, making a budget surplus bigger or a budget deficit smaller.

You might think this means that changes in the budget balance can be used to measure fiscal policy. In fact, economists often do just that: they use changes in the budget balance as a “quick-and-dirty” way to assess whether current fiscal policy is expansionary or contractionary. But they always keep in mind two reasons this quick-and-dirty approach is sometimes misleading:

To understand the second point, we need to examine the effects of the business cycle on the budget.