Question

Assume a hypothetical economy is currently operating at its full employment (potential GDP) situation as follows:

Yf = $400 (billion)

G =  $ 90b

T = 0.2Y.

Using the above information answer the following questions:

1. “In its current situation, this economy is facing a structural not a cyclical budget problem.” Evaluate. Agree or disagree and why? Show your calculations.
2. Calculate the level of GDP the economy would have to attain in order for the government to balance its budget.
3. Assume you have been hired to advise the Minister of Finance how to balance the government budget. Starting from Yf = $400, what changes in T OR in G would you recommend for this purpose? Show your calculations.

Answer 1

a) Structural slowdown in an economy have a long lasting impact on economy while cyclical slowdown occurs at regular intervals due to business activities and take economy to its natural level in some time. In the above case, tax revenue is 0.2 * 400 = 80b while government spending is 90b which result in deficit of 90b - 80b = 10b.

I would say this is cyclical shutdown because government can adopt contractionary fiscal policy by reducing government spending and raising tax which will take economy to its full employment level.

b) To balance the budget,

T = G

0.2Y = 90

Y = 450

Thus, level of GDP must be 450b to balance the budget.

c) To take economy to full employment level of GDP, I would suggest raising tax level because it will directly reduce the income left with consumers and reduce their spending while heat of cut in government expenditure will reach to public in few months.