Expansionary Fiscal Policy

Expansionary fiscal policy causes the deficit to increase at all levels of income, so the deficit line shifts upward. This picture illustrates the case of an increase in government purchases. Cyclically Adjusted Budget Deficit Given that the deficit depends on both the level of real GDP and the stance of fiscal policy, it is useful to have a way to distinguish these two influences. Put differently, it is helpful to know if the deficit is large because of the level of economic activity or because of the choices of government spending and taxes. This distinction came to the forefront in the 2004 presidential election in the United States. One of the issues raised in the debates between President George W. Bush and Senator Kerry was how the forecasted surplus from 2000 turned into the massive deficits of 2004. Were the deficits caused by the state of the economy or the policy decisions undertaken by President George W. Bush? To answer such questions, we need to decompose changes in the deficit into changes due to fiscal policy and changes due to the level of economic activity. The Congressional Budget Office  produces a measure of the budget deficit, called the cyclically adjusted budget deficit, for this purpose. The CBO first calculates a measure of potential output—the level of GDP when the economy is at full employment. Then it calculates the outlays and revenues of the federal government under the assumption that the economy is operating at potential GDP. The deficit is calculated by subtracting revenues from outlays. For obvious reasons, the cyclically adjusted budget deficit is also sometimes called the full-employment deficit. [2] Figure 14.9 “The Cyclically Adjusted Budget Deficit” illustrates this idea. We first calculate the level of potential output and then use the deficit line to tell us the cyclically adjusted budget deficit or surplus for the economy.