Cyclically Adjusted Budget

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Definition of Cyclically Adjusted Budget:

The cyclically adjusted budget is the budget that would occur if the economy were operating at full employment. The cyclically adjusted budget is also referred to as the full-employment budget. 

Detailed Explanation:

How much of a budget deficit (or surplus) results from a change in business activity, and how much of the deficit (or surplus) results from a change in fiscal policy? Economists use the cyclically adjusted budget to evaluate the expected influence of any change in tax or spending policies on economic growth. They begin by determining the budget deficit or surplus if the economy is at full employment or long-term equilibrium. When the cyclically adjusted budget is balanced, fiscal policy is neither expansionary nor contractionary – even if the economy has a budget deficit or surplus. The deficit or surplus results from business activity below or above the full-employment level. A fiscal policy is expansionary when there is a cyclically adjusted deficit and contractionary when there is a surplus in the cyclically adjusted budget. 

It is tempting to conclude that budget deficits always indicate the government is using expansionary fiscal policy. However, this may not be the case. When fiscal policy results in a balanced cyclically adjusted budget, the policy is neutral, even if the economy runs a deficit. The deficit was caused by a slowing economy rather than fiscal policy. To illustrate, assume in Year 1, the economy is at full employment and the budget is balanced. The cyclically adjusted budget would equal zero. The economy slows in Year 2, resulting in a budget deficit. Fiscal policy is unchanged, so the cyclically adjusted budget remains balanced. The deficit was caused by a slowdown in the economy rather than a change in policy. We would be wrong to conclude that the government is taking expansionary measures because the economy is running a deficit. Now assume the economy rebounds in Year 3, and there is a budget surplus. Again, fiscal policy is unchanged. The cyclically adjusted budget is balanced. The surplus resulted from a robust economy.

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